One of the changes of the SECURE Act was the elimination of the ‘Stretch IRA.’ The stretch IRA allowed IRA beneficiaries to take their required minimum distributions (RMD) over the course of their expected lifetimes. For young adults or minors, that provision might allow for an inherited IRA to last for 50 or 60 years (or longer).
With the SECURE Act changes, many people who stand to inherit IRAs are now subject to a 10-year rule, which requires a full withdrawal of the IRA balance over a 10-year period. Without proper tax planning, this can cause a significant tax impact to the beneficiary, particularly high-earning adult children who inherit large IRA balances.
Roth IRAs are also subject to the 10-year distribution rule, but those distributions are not taxable. They simply are not taxed upon distribution.
In response to the SECURE Act, many clients have asked the following question:
Can I pay taxes on Roth conversions now so that my beneficiaries pay less in taxes when they inherit my IRA?
The simple answer is, “Yes.” Anyone can always pay money for Roth conversions, for any reason, as long as they’re willing to pay the associated taxes. But the real question should be:
Should I pay taxes on Roth conversions now so that my beneficiaries pay less in taxes when they inherit my IRA?
The answer to that question is a little more complicated. There are a lot of factors that might play into this. We’ll take a look at some of these considerations in this article.
Roth Conversion Consideration #1: What is my goal, and what are my priorities?
This is a very overlooked, but very important part of the overall answer. Being clear on what your goal is (and more importantly, what it is not) will help you make decisions that you will be satisfied with. Here are some goals many people want to look at:
How do I pay the least amount of taxes on my IRAs?
How do we (my heirs and I) pay the least amount of combined taxes on my IRAs?
How can I minimize the amount of taxes my heirs will have to pay?
Whatever the goal is, it’s important to have something you’re trying to achieve. Otherwise, you might end up disappointed in the result.
Roth Conversion Consideration #2: How much are we trying to achieve?
It’s much easier to plan a tax-efficient strategy for a $500,000 account balance than it is for a $5 million balance. Regardless of your goal, the size of your account balance will have a direct impact on your ability to achieve it. And it will absolutely impact how much you (and/or your heirs) pay in taxes along the way.
Roth Conversion Consideration #3: What is your tax bracket?
Many people pondering this question are retirees, who might be in a lower tax bracket than their adult children. This is particularly true for older people whose children are well into their professional careers.
If that’s the case, then ‘tax arbitrage’ might make sense. In other words, a retiree in the 12% tax bracket who is converting a $1 million IRA can put together a multi-year Roth conversion strategy that will keep them in the 12% tax bracket. Over the course of executing that strategy, that retiree can expect to pay $120,000 ($1 million X 12% = $120,000). That could be much less than your heirs might pay. Furthermore, it might make sense simply because you, as the account holder, have access to tax-free withdrawals from your IRA for the rest of your life.
But what if I’m in a higher tax bracket? That’s a worthy question, and does merit consideration. But that’s only one side of the story. It’s worth considering your tax bracket, versus the tax bracket of your beneficiaries.
Roth Conversion Consideration #4: What is the tax bracket of the people who stand to inherit?
Let’s go back to the example of the retiree at the 12% tax bracket.
If the adult daughter of that retiree inherits that $1 million IRA, and her family is in the 24% tax bracket, then 24% is probably the lowest tax bracket she can expect to remain in, barring unforeseen circumstances, like losing her job. Instead of paying $120,000 in taxes, she’s looking at paying $240,000 at the very least.
And since this $1 million IRA has to be distributed over 10 years, then the average IRA distribution is $100,000 per year. This raises the very significant possibility that this bumps her to the next tax bracket (32%), which means that some of her income would be taxed at 32%, instead of 24%.
And, if for some reason, she waits until the tenth year to do anything about her IRA, then all of her IRA has to be distributed by the end of that year. That is enough to put her in the highest tax bracket, where a significant amount of income would be taxed at 37%.
Certainly, from the perspective of the inheritor, some money is better than no money at all. But would that retiree have done things differently had he known how much more in taxes his daughter would have paid on that same IRA? Perhaps. Perhaps not.
And that leads us to the most important consideration of all.
Roth Conversion Consideration #5: What do you want?
This sounds a lot like #1. But there is a difference.
A goal is something that you’re looking to achieve. For example, I’d like to convert my entire IRA at the 22% tax bracket or lower, and I’d like to do that in 10 years. You might be able to do that, or you might not. But you establish your goal, talk with your tax professional or your financial advisor, and run the numbers to see if that’s feasible.
If it’s feasible, that’s great. But if it’s not feasible, you might still want to do it anyway. If you can’t convert everything at the 12% tax bracket, but you really don’t want your children to pay taxes on their withdrawals, then you might decide to do the best you can and do the Roth conversions anyway. It might not make the most sense, or the numbers might not justify why you’re doing this, but you might do it anyway.
That’s your money. And that means it’s your choice.
And because of that, people in the 32% tax bracket may choose to pay more in taxes so their child in the 12% tax bracket doesn’t have to. Or people in the 12% tax bracket might decide they don’t want to pay a single dime more in taxes over their lifetimes, so they let their kids figure it out. That’s fine too. It’s your money.
This article was written after several clients asked this question. There is no ‘right’ or ‘wrong’ answer. But it doesn’t mean that this question isn’t worth exploring. Perhaps you come to your right answer only after taking some time to really think about how this might play out.
If this is an important question to you, then you should talk with your financial advisor. And if you don’t have one, or your current advisor won’t help you, then contact us. We would be more than happy to schedule a complimentary appointment to see how we might be of service to you.