You’ve spent a lifetime accumulating wealth in your individual retirement accounts (IRAs). You’ve set up your beneficiary designations so most of your wealth bypasses the probate process. What else can you do to help your estate plan?
Roth IRA conversions can be a powerful estate planning tool. They can be a great way to manage your tax liability over your lifetime and keep your federal income tax low.
But there are additional considerations about how your retirement accounts might impact the tax liability of your IRA beneficiaries after you pass away.
The passing of the Setting Every Community Up For Retirement Enhancement (SECURE Act) means that you can no longer use the stretch IRA. A stretch IRA is when an IRA beneficiary had to take annual required minimum distributions (RMDs). However, they could ‘stretch’ their RMDs over their life expectancy.
No more. A beneficiary has 10 years to completely empty the inherited IRA and pay any income taxes. There are two exceptions:
- Eligible designated beneficiaries (EDB)
- Spousal beneficiaries
Now, unless he or she qualifies as an eligible designated beneficiary (EDB), a non-spousal beneficiary will have to incorporate this into their own tax planning.
There are two approaches that you, as the original IRA owner, could use to help lessen the tax bill for yourself and future generations who stand to benefit from your wealth:
- Sit down with the person and have a frank discussion about what they might inherit. This might inspire them to hire their own financial advisor to help them with this and other financial decisions. At the very least, they’ll know that there are tax consequences for their inherited IRA.
- Incorporate this into your own Roth IRA conversion strategy. Beneficiaries of Roth accounts are subject to the same 10-year IRA distribution rules as traditional IRA beneficiaries. However, they do not have to pay taxes on their Roth distributions. They are considered tax-free income.
Using both approaches would help provide clarity for everyone involved. And it’s a way to lower taxable income so that Uncle Sam keeps less of your tax dollars.
However, many families are reluctant to talk about money. Many original account holders don’t want to share details about their accounts with their adult children, who might be their primary beneficiaries. They’re even more skeptical about talking with their grandchildren, who might be contingent beneficiaries.
With that in mind, here are five things to consider if you plan to use Roth conversions as part of your estate planning.
Roth Conversion Consideration #1: Keep your beneficiaries from paying taxes on your retirement assets.
If you’re in a desirable tax bracket for Roth conversions, you might pay less in taxes over your timeframe than your beneficiaries. This is especially true if any (or more than one) of the following conditions apply:
- You’re retired and already in a low-income tax bracket
- You don’t have a lot of tax-deferred income, like annuities or pensions.
This happens a lot for recent retirees. There’s a window of opportunity to take advantage of lower tax rates between retirement and when you apply for Social Security benefits.
And you might be in a lower tax rate than your beneficiaries. Especially if they have high incomes. And if they’re doing well enough, future promotions could push them into a higher tax bracket.
If you’re working with a tax-focused financial advisor, you can decide whether you should do Roth conversions at lower income tax rates so your beneficiaries don’t have to.
Roth Conversion Consideration #2: Your beneficiaries have up to 10 years of tax-free investment growth before they have to take the money out.
Whether it’s an inherited traditional IRA or inherited Roth IRA, your beneficiaries have up to 10 years to empty their accounts. However, they are no longer subject to minimum distribution rules.
In the case of a traditional retirement account, it would make sense to create a plan to space withdrawals out over time. This would help keep income taxes low, especially if the account went to a sole beneficiary.
Of course, your beneficiaries would want to revisit the plan each year as part of tax planning with their financial advisor or tax professional. That way, they could:
- Lower distributions in years where they expect higher income
- Increase distributions in years where they expect less income
With an inherited Roth account, none of that is a concern. The beneficiary of the IRA no longer has to make minimum withdrawals. And all of their withdrawals are considered tax-free distributions.
The only concern is that at the end of 10 years, the Roth IRA balances are down to zero. That means your beneficiaries could let the entire account balance grow over a full ten years.
Then, at the end of the period, they could liquidate their holdings and withdraw the entire amount tax free.
But what if you did some Roth conversions, but then passed away before you could convert everything. Well, that leads us to our next item.
Roth Conversion Consideration #3: Your surviving spouse can continue where you left off.
One plan, two lifetimes.
Your Roth conversion plan doesn’t have to just cover whatever you expect to convert in your lifetime. Your surviving spouse can do the same thing.
There could be certain considerations, such as:
- Changing in tax filing status
- Changes in financial planning needs
- Changes based on your surviving spouse’s wants
And it’s another reason why you might want to take the time to make sure you mutually understand (and agree) on what you want. And if you need help, it would be a good idea to talk with a financial planner on the best retirement strategies for both of you.
But even if you and your spouse aren’t able to convert everything, there might be situations where your contingent beneficiaries aren’t subject to the 10-year rule.
Roth Conversion Consideration #4: Your beneficiaries don’t necessarily have only ten years.
The 10-year rule does not apply to eligible designated beneficiaries (EDBs). EDBs fall into one of the following 5 categories:
- Spouses: A surviving spouse has a couple of options.
- He or she can simply roll a retirement account into their own account. From there, they would simply treat it as one big account.
- They can also keep the separate account and not be required to take RMDs until the year that the deceased spouse would have reached age 72. This might be a consideration for surviving spouses who are already taking RMDs and don’t want to increase them.
- Disabled individuals: The individual in question must meet the disability criteria as outlined in Internal Revenue Code Section 72(m)(7), which is fairly restrictive.
- You may want to consult an experienced estate planning or disability attorney to make sure this applies to your beneficiary’s situation.
- Chronically ill persons: There is an Internal Revenue Code (IRC) definition of ‘chronically ill,’ as outlined in Section 7702B(c)(2).
- However, the SECURE Act requires that to be considered an EDB, this impairment must be considered ‘an indefinite one which is reasonably expected to be lengthy in nature.” Seek legal advice.
- Individuals who are not more than 10 years younger than the decedent. These people are allowed to ‘stretch’ distributions without regard to the SECURE Act.
- Examples of EDBs might be siblings, parents, or unmarried partners.
- Minor children of the decedent. A couple of nuances here:
- This definition of minor children means direct children of the decedent.
- This does not include children or minors who happen to be beneficiaries, like grandchildren.
- This is a temporary status, and the stretch provision only applies until the beneficiary reaches the age of majority.
- Then, the 10-year rule kicks in.
- The age of majority depends on which state the minor beneficiary lives in, not the account owner.
- If your beneficiaries might be considered EDBs for any reason, you should clarify this with your financial advisor just to be sure.
Roth Conversion Consideration #5: You won’t avoid estate taxes (if applicable), but you can lessen the bite.
In 2020, the estate tax exemption was $11.7 million per person (or $23.4 million for a married couple). According to Business Insider Magazine, fewer than 2,000 families were estimated to have paid federal estate taxes for 2020.
However, legislation is always subject to change. Recently, there has been serious debate in Congress about whether to lower the estate tax exemption (and make more households subject to an estate tax).
Furthermore, the tax is not cheap—40% on any estate values above the exemption amount.
But wait—it gets better. For assets that are handed down to grandchildren (above the exemption amount), there is a generation-skipping transfer tax (GSTT), which adds another 40% to the 40% estate tax. This represents 64% of the amount transferred from the original account owner.
And that’s just for the federal side. There are 17 states that impose their own estate taxes. Each state has their own rules, but the taxes can be as high as 20%. Also, not every state follows the federal exemption guidelines. For example, Oregon’s exemption ends at $1 million.
Estate planning for tax purposes is beyond the scope of this article. However, it seems that Roth conversions can help mitigate some of the overall tax responsibility that a beneficiary might face when inheriting a taxable estate.
And that’s an important consideration to discuss with your estate attorney or financial advisor.
Roth conversions can be a great tax and retirement planning tool, when done properly. In addition to optimizing your lifelong tax liability, Roth conversions can often lower the overall tax bill that you and your
After retiring from a 24-year career as a Naval officer in 2017, Forrest became a financial planner to help people achieve success in managing their personal finances. In 2022, he sold his partnership stake in his financial planning firm to focus on helping people full-time through his writing.
Featured in: Forrest’s writing has been featured in the following publications: Forbes, Military.com, NerdWallet, Yahoo Finance, The Military Guide, The Military Wallet, Christian Science Monitor, and many other publications.
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