3 Ways A Roth Conversion Can Build and Preserve Wealth

When it comes to building and preserving wealth, Roth IRAs can offer tax savings to individuals and their heirs in certain situations. Often because of IRA income limits, many higher net worth families are under the impression that they don’t qualify to have a Roth IRA.  In fact, these income limits do not apply to Roth conversions. Anyone can convert IRA assets to a Roth, no matter their income level.

In working with high-net worth clients, I find that there many situations where someone should look into converting their traditional IRA into a Roth IRA.  Three great examples are to stretch their retirement income, to avoid issues for a special needs family member who inherits an IRA, and to more effectively plan an estate by reducing the estate and income taxes family members would have to pay when they inherit.

Before we look at the details, I have a word of caution—IRA conversions can have significant tax implications, so it’s best to consult your CPA before implementing any Roth conversion strategy.

Stretching retirement income

One of the benefits of a Roth IRA for retirees is that they are exempt from the required minimum distribution (RMD) rules during an owner’s life.  If you have saved a substantial amount in your retirement plan at work or have traditional IRAs where you are required to take distributions starting at age 70 ½, you may benefit from a conversion that reduces your IRA balance and your annual RMDs. This can be a good way to increase the longevity of your portfolio because you’re not forced to take distributions you don’t need and your assets grow tax-free in the Roth IRA.

Your decision to convert traditional IRA assets to a Roth hinges primarily on comparing your current income tax rate to your projected income tax rate in retirement.  Conversion will be advantageous only if the current tax rate is lower than the expected future marginal tax rate.  Having a tax advisor project potential tax brackets will help you get a better understanding if a Roth conversion makes sense for you.

If the aim is to reduce your RMDs, then a more optimal strategy is to do partial conversions over several years before age 70 ½ as opposed to a full conversion all in one year.  With this strategy, traditional IRA owners convert just enough to fill the lower tax brackets, but not enough to trigger top tax bracket rates.

What happens if you inadvertently push yourself into a higher bracket by converting too much of your IRA balance?  The recharacterization rule allows you to effectively undo a conversion. If this occurs, the IRS lets you to undo a portion or all of a prior year’s Roth conversion to arrive at a more optimal level.  Recharacterizations must be done by the tax filing deadline and can be completed as late the October 15th tax filing deadline, so long as you file an extension.

Inheritors who have special needs and receive government assistance

You may sometimes hear that Roth IRAs are not subject to Required Minimum Distributions.  That’s only partially true.  Original owners of the assets are not subject to RMD rules for their own Roth IRA.  Inheritors, on the other hand, do have RMD requirements when they inherit retirement assets, including Roth IRAs.

Where this can be problematic is when an inheriting beneficiary has special needs. If a disabled person is named personally as a direct beneficiary, they could lose their needs-based assistance if this income exceeds the thresholds to qualify for these services.  So, if you are settling an estate and someone with special needs is the beneficiary of a Roth IRA, you’ll want to consider establishing a special needs trust to receive that beneficiary’s share of the inherited IRA.  If you are establishing your estate plan and have a beneficiary in these circumstances, confirm that your Roth IRA account beneficiary designations reflects the existence of a special needs trust.

Another way to provide for someone with special needs is to convert IRA assets into a Roth and then provide for a special needs accumulation trust.  An accumulation trust is preferable to a regular special needs trust because the inheritors’ Roth RMD can either be distributed to them or held for accumulation inside the trust.  The major downside of holding distributions in the accumulation trust is that the rate on taxes that the trust must pay is generally higher than the individual’s rate.  However, if the beneficiary would be at risk of losing subsidized services, then some families choose to incur the higher tax.  Establishing an accumulation trust gives the trustee more flexibility to manage distributions and taxes, and distribute funds in the way that is most beneficial to someone with special needs.

Read more about Inherited IRA Rules.

In all cases, it’s wise to seek assistance from an estate planning attorney to consider all of your options.

Saving taxes for heirs when distributing an estate

When planning their estate, some older generation family members want to pay the taxes on IRA balances as an extra benefit to their beneficiaries. Perhaps they have more than enough wealth to meet their needs while they are living and they want to maximize the money they gift to their intended heirs.

If you expect your total estate to fall below the federal estate individual exemption amount ($5.49 million in 2017), the main question to ask is, “Who in the family has a lower tax rate – me or the eventual beneficiary of the IRA account?”  Although this may sound like a simple matter of reviewing your tax returns or consulting your CPA, there are many factors that come into play when predicting future tax rates. These include the state of residence (now and in the future) of you and your heirs, current and future employment income of the beneficiary, and how a beneficiary’s income may increase as a result of income from inherited assets.

Even if you have substantial wealth in terms of total assets, it’s possible your income level is lower than your beneficiaries. Here’s where it makes more sense for the IRA owner to pay the taxes for their high income earning beneficiary because it would reduce the total taxes paid by the family.  If you have a mix of both taxable IRAs and nontaxable Roth accounts, then consider establishing a legacy plan that factors in any tax bracket differences of your beneficiaries.

In cases where someone’s overall estate value exceeds $5.49 million, the wealth preserving aspects of a Roth conversion may make it a wise financial decision.  For example, if an affluent individual has a $12 million net worth that includes a traditional IRA worth $1 million, the total potential tax burden on the IRA could be as high as $796,000 once you factor in the estate tax of $400,000 (40%) plus income taxation of $396,000 on distributions from the regular IRA to beneficiaries (if they are in the top tax bracket).

To counteract this degradation in the total estate value, you can trigger a “death bed Roth conversion.” The IRA owner pays the conversion taxes up front, thereby reducing the size of the estate to below the exemption amount.

Keep in mind that if you are attempting to rapidly diminish an estate before death by converting everything to a Roth all at once, usually the sheer magnitude of the conversion results in the likelihood that most or all of the conversion will be taxed at the top ordinary income tax rates. So if there is time, utilize a strategy that does partial conversions over time or split conversions over two tax years to reduce the average income tax rate paid below the top tax rate.

Be opportunistic

If none of these circumstances apply to you, there still may be a reason to consider a Roth conversion.

Opportunities arise when life situations result in a lower income tax bracket in a particular year.

Consider any year that your income is lower than a typical year as a potentially opportune time to complete a Roth conversion, such as:

  • ‍You are unemployed for part of the year
  • You have high deductions (i.e. a high medical expense year), making income low or negative
  • You own a pass-through business that experiences a loss
  • You have a gap between your retirement date and when Social Security, pensions, and RMDs begin

If any of these circumstances apply to you, and if you have a traditional IRA or rollover IRA, consider asking your CPA or financial advisor to determine whether this is a good tax year to convert to a Roth IRA.  Remember that conversions must be done by the end of the calendar year, December 31st, so don’t wait until the last week of December to make this decision.

Roth conversions are an effective strategy for reducing taxes in many circumstances. This sophisticated planning technique can be useful if undertaken with care and the guidance of advisors familiar with all of the various dimensions of your wealth and a clear understanding of your goals.