November 7, 2022
Estate Planning with Roth IRA Conversions
Often an individual will say that they are too old to engage in a Roth IRA conversion. Their fear is that the tax-free benefits of owning a Roth IRA with a shortened life expectancy will be outweighed by the up-front income tax cost that comes with the Roth conversion.
The reality is that an individual is never too old to convert their traditional IRA to a Roth IRA, despite the ‘trade-off’ of incurring an immediate income tax on the conversion to the Roth IRA’s tax-free income. Such an individual, regardless of their age, might be more motivated to consider a Roth conversion if they view their Roth IRA as an important part of their comprehensive estate plan, a plan which they make to benefit their children and grandchildren and not for themselves.
Some of the benefits that are associated with the inheritance of a Roth IRA include:
A Roth conversion today eliminates the income tax bill the beneficiary will otherwise pay later when a traditional IRA is inherited. In effect, the converting IRA owner pays the income taxes, not the beneficiary of the Roth IRA. The payment of the income tax on the conversion is the equivalent of an advance gift: “I have paid your future income taxes.”
If a traditional IRA is inherited, the beneficiary normally must take taxable distributions from that traditional IRA over 10 years. With the recently proposed SECURE Act Regulations, if the traditional IRA owner was over the age of 72 at the time of his/her death, then their beneficiary must take the taxable distributions over the next 10 years after the account owner’s death.
Instead, if a Roth IRA is inherited, the Roth IRA owner is treated as having died before attaining age 72. This means that the beneficiary who inherits a Roth IRA is not required to take annual distributions from the inherited Roth IRA. This means that the Roth IRA beneficiary can accumulate the income generated inside the Roth IRA, income tax-free, for the 10 years that follow the Roth IRA owner’s death. Ten years of tax-free income is a nice asset to inherit.
If the IRA owner feels that the IRA should be paid to a trust instead of outright to their children or grandchildren as beneficiaries, a Roth IRA is a much better asset to direct to that trust rather than a traditional IRA. A traditional IRA that is paid to an irrevocable trust results in taxable income paid to the trust; an irrevocable trust much more quickly reaches the highest marginal federal income tax bracket than an individual. Accordingly, if the taxable income from the traditional IRA paid to the trust is accumulated inside the trust, it will be taxed at the 37% marginal federal income tax bracket once the trust’s accumulated income exceeds $11,000. If a Roth IRA is made payable to the trust, there will be no bunching of income inside the trust, since distributions from Roth IRAs are all income tax-free.
The income taxes that traditional IRA owner pays on the conversion of their IRA to a Roth IRA will obviously deplete the size of their gross estate, i.e. the dollars used to pay the income tax liability on the conversion will disappear from their estate. If the IRA owner is concerned about federal estate tax liability [remember the currently large gift and estate tax exemption of $12.06 million is scheduled to be cut in half beginning in 2026] then the payment of the income tax liability now could reduce the potential size of the IRA owner’s taxable estate at a later date.
As with any estate planning strategy, there are also some obvious cautionary remarks that need to be considered before making the decision to convert a traditional IRA to a Roth IRA.
A Roth IRA conversion will increase the account owner’s ordinary income for the year of the conversion. This one-time increase in reported taxable income could potentially cause the IRA owner to lose valuable income tax credits and deductions, or possibly affect their eligibility to receive some governmental benefits that are means-based.
That additional increase in the account owner’s reported taxable income in the year of the Roth IRA conversion could result in the taxation of the account owner’s Social Security.
That additional increase in the account owner’s reported taxable income in the year of the Roth IRA conversion could result in the increase of premiums paid for Medicare Part B and Part D premiums.
Since income taxes will have to be paid on the Roth IRA conversion, the account owner may have to liquidate other assets and incur a capital gain in order to create the liquidity needed to pay the income tax liability associated with the Roth conversion. It is much better to have cash on-hand to pay the tax liability caused by the conversion.
Traditional IRA owners age 72 and older also need to understand that their annual required minimum distribution (RMD) is not eligible for a Roth conversion. The first money that comes out of a traditional IRA is the owner’s RMD for the calendar year when they are age 72. That means that the owner’s RMD for the calendar year must be paid out first before the Roth IRA conversion can be completed. However, after the Roth conversion, there will be no more RMDs the account owner must take.
Finally, with any Roth IRA, the Roth account must be opened and held for at least five years before the income that is generated by the Roth IRA can be distributed to the Roth owner without any income tax. However, the funds rolled over from the traditional IRA to the converted Roth IRA (on which the account owner just paid the income tax liability) are always distributed from the Roth IRA tax-free, and those funds will be the first to the be distributed from the Roth IRA.
A Roth IRA always makes sense for those individuals who are concerned about future income taxes and income tax rate increases. While an older traditional IRA owner may believe that he or she does not have a long time to reap the benefits of a Roth IRA (tax-free income, no RMDs) they should at least factor into their decision-making process the potential estate planning benefits that their children and grandchildren will derive if they inherit a Roth IRA.