Roth conversions can be a great way to manage your tax liability over your lifetime. But there are additional considerations about how your retirement accounts might impact the tax liability of your heirs after you pass away.
The passing of the SECURE Act did away with the ‘stretch IRA’ for most beneficiaries. Under the previous rules, an IRA beneficiary had to take annual required minimum distributions (RMDs), but could ‘stretch’ their RMDs over the course of their expected life.
No more. Now, unless he or she qualifies as an eligible designated beneficiary (EDB), a beneficiary has 10 years (almost 11, depending on the timing of the inherited account) to completely empty the account (and pay any applicable taxes). A significant challenge with this change lies in whether the beneficiary completely understands this and incorporates this into his or her own tax planning.
There are two approaches that could help to lessen the tax bill for these beneficiaries:
- Sit down with the person and have a frank discussion about what they might inherit. This might lead to them hiring their own financial advisor, or at least just having a basic plan for what they’ll do when they inherit the account.
- Incorporate this into your own Roth conversion strategy. While beneficiaries of Roth accounts are subject to the same 10-year distribution rules as beneficiaries of traditional accounts, they do not have to pay taxes on their Roth distributions.
Using both approaches would help provide clarity (and possibly lower lifelong taxes for everyone involved). However, many families are reluctant to talk about money, and many account holders don’t want to share details about their accounts with their adult children (who usually inherit the money).
With that in mind, here are five considerations about the second approach:
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 already in a low-income tax bracket
- You don’t have a lot of tax-deferred income, like annuities or pensions.
Even if you do, you might still have a window of opportunity to do Roth conversions tax efficiently before that income becomes a factor
- Your beneficiaries have high incomes
We won’t go into a whole lot of detail here—for more information, you can check out the following article: Do I Want To Pay Taxes on Roth Conversions So My 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.
In either IRA situation, your beneficiaries have up to 10 years before their inherited retirement accounts have to be completely emptied. While circumstances can vary, let’s assume this to be the worst-case scenario (some situations might have more flexibility).
In the case of a traditional retirement account, it would make sense to create a systematic plan where withdrawals are made over the full period. This would have a higher likelihood of avoiding tax bracket creep, where the taxpayer ends up going into a higher tax bracket than they could have. 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 than average income, and increase distributions in years where they expect more.
With a Roth account, none of that is a concern. The primary matter is that at the end of 10 years, the account is empty. That means your beneficiaries could let the entire account balance grow over full ten years. Then, at the end of the period, they could liquidate their holdings and withdraw the entire balance tax free.
Of course, this is the worst case scenario, like if you did nothing at all. But what if you did some Roth conversions, and passed away before you could convert everything you wanted. 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 spouse can do the same thing. While there might be certain considerations, such as changes in tax filing status, changes in strategy, or even changes based on what your widow(er) would like to do—this is important to keep in mind.
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. But even if you and your spouse aren’t able to convert everything, there might be situations where your 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 can simply roll a retirement account into their own account (and treat it as one big account). However, 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
- 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 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—not 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. And the age of majority depends on which state the minor beneficiary lives in, not the account owner. Needless to say, 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 estate taxes for 2020.
However, legislation is always subject to change. At the time of this writing (March 2021), 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, because 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, or 64% of the transferred amount.
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 sizeable estate. And that’s an important consideration to discuss with your estate attorney or financial advisor.
Roth conversions can be a great tax 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 beneficiaries ultimately pay.
Interested in reading more about Roth conversions? Check out Lawrence Financial Planning’s Roth conversions articles page. Here you’ll find lots of articles that we’ve written about Roth conversions.
And if you’re ready to take the next step and work with a financial planner, you can learn more about how we work with clients right here.