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Year-End Roth Conversions for Wealth Transfer

DEC. 17, 2019

I was recently speaking to a group of advisors about the advantages of year end Roth conversions when someone voiced a common objection – “why should retired clients pay taxes now to do a Roth conversion? After all, it’s not like they are going to find themselves in a much higher tax bracket later in retirement.” This is a good observation, as one of the best arguments in favor of a Roth conversion is paying a lower tax rate now to avoid a higher tax rate in the future.

By that logic, if a retiree has a set level of income that will remain constant through retirement, the case to convert traditional IRA assets to a Roth IRA may not be very strong. For retirees with large balances in qualified accounts, however, there are additional factors to consider. Chief among those is the fact that they may not be the person who ultimately pays taxes on those accounts. In many cases, it will be their children.

Let’s consider a scenario based on 2019 tax rates. Let’s assume that I’m a married retiree who can get by on $28,950 of taxable income a year (remember that taxable income is total income less our standard deduction of $26,600 or itemized deductions if higher).[i] This means that I would be able to convert $50,000 of traditional IRA assets to a Roth IRA at a 12% tax rate, incurring a tax on the conversion of $6,000 (the 22% bracket begins at taxable income of $78,950 for married joint filers).[ii] Let’s further assume that I go ahead and pay the taxes due on the conversion from my Roth, leaving a balance of $44,000. The beneficiary of both my traditional IRA and my Roth IRA is my 50-year-old daughter.

My daughter and her husband have taxable income of $250,000 per year, putting them right in the middle of the 24% bracket.[iii] If they were to inherit $50,000 of traditional IRA assets from me, they would have to pay $12,000 in taxes when they liquidate that account, leaving them $38,000. I think we can all agree that inheriting the $44,000 Roth IRA would be a better deal for them.

In addition, the tax impact of inheriting a large IRA could be changing soon. Under new guidelines established by the SECURE Act, non-spouse beneficiaries will lose the ability to spread distributions from an inherited IRA over their life expectancy.[iv] The so-called “stretch IRA” option has been replaced by a ten-year distribution timeframe. For my 50-year-old daughter, her potential distribution period would shrink from 34.2 years to ten years.[v] For many beneficiaries, this will cause a dramatic acceleration in the liquidation of the inherited IRA and potentially exposing those assets to higher tax rates. Roth IRAs will also be subject to the new distribution rules, but because those distributions are tax-free to beneficiaries, they are not exposed to higher tax rates.

Finally, leveraging Roth conversions early in retirement can also benefit the retiree by reducing future RMDs from the account. A retiree with a $500,000 traditional IRA would have an RMD at 70 ½ of approximately $19,000. If that retiree can leverage multiple Roth conversions to reduce that IRA balance to $250,000 when RMDs begin, the initial RMD would be approximately $9,500.[vi] Lower RMDs can give retirees more control over their tax bills in retirement.

Roth conversion strategies won’t make sense in every scenario. For retirees who are not fully utilizing their lower tax brackets, however, Roth conversions can be a very effective wealth transfer tool (and a great way to turn beneficiaries into clients). They can also help reduce future RMDs. Year-end is the perfect time to talk to clients about whether a conversion will make sense for them. To count for the 2019 tax year, conversions must be completed by December 31, 2019.

[i] See IRS Form 1040

[ii] https://taxfoundation.org/2019-tax-brackets/

[iii] https://taxfoundation.org/2019-tax-brackets/

[iv] SECURE Act Summary, House Committee on Ways and Means

[v] IRS Publication 590-B, Appendix B, Table I

[vi] IRS Publication 590-B, Appendix B, Table III

Disclosure

  • Neither Nationwide nor its representatives give legal or tax advice.  Please have your clients consult with their attorney or tax advisor for answers to their specific tax questions.

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