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Roth Conversions for Income Tax-Free Inheritance

How much do you love your adult children?  Enough to pay their future income taxes for them?  If yes, then read on.

While Roth IRAs are often over-hyped as a financial tool, they can provide a powerful benefit as an income tax-free inheritance vehicle.

The Concept

A retired individual converts all or a portion of their traditional IRA into a Roth IRA.  This conversion may happen in one tax year or be spread out over multiple years.  Upon conversion, the traditional IRA owner pays current year income tax on the amount converted (preferably from non-IRA funds).  The owner of the new Roth IRA names a spouse as primary beneficiary, and the their adult child(ren) as contingent beneficiaries.  During the account owner's lifetime, there are no Required Minimum Distributions (RMDs) and no more income taxes, leaving the Roth dollars to grow income tax-free.  Upon the Roth account owner's death, the surviving spouse takes over the account, again leaving it to grow tax-free.  At the surviving spouse's death, the adult children inherit an account that should have grown substantially, and must withdraw all the Roth dollars within 10 years.

Who Should Consider This Technique?

This technique works best if you:

  • Have significant balances in traditional IRAs.
  • Don't expect to spend all those dollars in your or your surviving spouse's lifetime.
  • Have kids in a higher tax bracket than you (likely kids in their 30's-50's who are in peak earning years).
  • Have non-IRA dollars laying around to pay current year tax on the Roth conversion.  If you have to raid the IRA to raise the money to pay the tax, the benefit of this technique is greatly reduced.
  • Are confident you want to leave these IRA assets to your kids and won't change your mind later.

Why Is This Technique Useful Now?

In 2019 Congress passed the SECURE Act.  Among other things, the law introduced a new requirement that non-spousal beneficiaries of IRAs (i.e. your kids) must withdraw the entire balance of an inherited IRA within 10 years of receiving it.  The prior rule only required withdrawals over the beneficiary's remaining life expectancy, which could have been a very long time.  The 10 year rule was a negative for beneficiaries.

Unlike traditional IRAs, Roth IRA withdrawals are income tax-free.  Yet most beneficiaries today are receiving traditional IRAs.  That means they suddenly have to spend down the IRA over a shortened timeframe, potentially pushing them into a much higher tax bracket right when they are at their peak earning years. 

While the 10 year requirement of the SECURE Act was bad news for beneficiaries, at least there is not a Required Minimum Distribution (RMD) each year.  The beneficiary must simply withdraw all funds within 10 years.  A smart beneficiary will wait as long as possible before taking withdrawals.

At the time of this writing, Congress is debating raising income taxes on any couple earning $400,000 or more.  If your children are in such a bracket, they already face potentially higher income taxes.  Imagine if they were to receive a traditional IRA on top of their normal income and were forced to start taking taxable distributions.  Even if they aren't making more than $400,000, every dollar they withdraw from a traditional IRA inflates their taxable income.  So, a couple earning $100,000 who inherits and liquidates a $300,000 traditional IRA is suddenly in the top income tax bracket that year.  With proposed top federal rates of 39.6%, plus state taxes on top of that, your beneficiaries could easily be losing 40%-50% of the IRA to taxes.  Ouch!

 

I Want to Convert!

If you think a Roth conversion might be right for you, keep in mind:

  • You will owe current year income tax on the Roth conversion amount, even though you are not receiving any cash to pay the taxes.  
  • Be careful not to convert "too much" in any one year, or you may push yourself into a higher income tax bracket, thereby diminishing the value of this technique.  You should also take into consideration your effective tax rate vs. your child's; the wider the spread between theirs and yours, the more useful this technique can be. Working with a knowledgeable CPA is a must here.
  • Invest it for long-term growth.  Every dollar in the Roth is exempt from tax, so your goal should be to grow this to the sky in order to maximize the inheritance.
  • Your kids should be instructed to leave the Roth account alone as long as possible in order to maximize income tax-free growth.  This could mean waiting 10 years before accessing the money.
  • All references to tax savings in this article are income taxes.  Estate/death taxes may still apply depending on your situation and are beyond the scope of this article.  Please consult with a knowledgeable professional and keep abreast of changes in Congress in regards to estate taxes.

A Financial Partner

Roth conversions are a tricky area, and most often are not for everyone.  It takes careful advice and coordination from investment and tax professionals to determine what's best for your situation.

We've been helping clients prepare for, and thrive in retirement for over three decades.  Our clients' continued financial success is exceeded only by their success at the game of life.

When we build retiree portfolios at Oxford, we seek a balance between Stability and Growth following the principles outlined in our proprietary Power of 5 Investing system. Our goal is to help clients achieve inflation-beating growth in their wealth, while managing through market downturns, ultimately helping clients leave a legacy to the people and places they love.  Our system has been battle tested in 25+ years of market ups and downs and is ready for whatever the market can throw at it.

If you'd like to discuss a Roth conversion, click on the link below to schedule a free Get Acquainted meeting.

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