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  • Writer's pictureThomas Hayes

Roth Conversions for Generational Wealth Transfers

One major change to the retirement landscape in the past few years has been the adjustments to withdrawal rules made by the SECURE Act, passed in December of 2019*. Prior to the SECURE Act, individual beneficiaries were able to stretch out RMD (Required Minimum Distribution) payments based on a beneficiary’s remaining life expectancy at the time of inheritance. This provided an incentive for retirees to keep the funds in the tax-advantaged account, as their beneficiary would be able to stretch out withdrawals and benefit from the on-going tax deferral. However, the SECURE act lays out new withdrawal provisions, which state that only "eligible designated beneficiaries" can use the life expectancy calculation to extended withdrawals. These eligible designated beneficiaries include the following *(1) a surviving spouse; (2) minor children; (3) disabled or chronically ill beneficiaries; and (4) a beneficiary who is not an individual described in the preceding clauses (1) through (3) but who is not more than 10 years younger than the participant. This leaves most beneficiaries with a requirement to withdraw the funds with 10 years.

So how does this change things?

For anyone outside that eligible designated beneficiary category, such as adult children inheriting a parents IRA's, this has huge implications for generational wealth planning. Depending on the size of the IRA, a 10-year withdrawal schedule could potentially bump the beneficiary into a significantly higher tax bracket. Let's look at an example, an individual passes away with $2,000,000 in an IRA account, naming their daughter as the sole beneficiary. She now has the obligation to withdraw all $2,000,000 from the account within the 10-year period allotted, all of which will be added to her taxable income. Of course, the problem becomes obvious, she will have to withdraw a minimum of $200,000 per year at a minimum in order to draw down the account on time. If the daughter has an annual income of $80,000, her income in a given year would be pushed up to $280,000 by the withdrawals, causing $115,074 of the withdrawal to be taxed at 32% vs her original tax bracket of 24%. (Link to tax brackets) This 8% difference amounts to an extra $9,205.92 in taxes per year. Unfortunately, even if the withdrawals are not taken in equal $200,000 per year increments, the IRA balance is so large that there is no way to avoid being pushed into the 32% bracket on a portion of the withdrawal. However, looking at the IRA through the lens of a generational wealth transfer, there are some ways to mitigate the tax hit.

Roth IRA conversions are an option to consider. Let's go back to our client with a $2,000,000 IRA balance and assume that at age 78, he is in poor health, and it becomes apparent he may only have a few years left to live. Assuming that his IRA balance is more than sufficient to meet his living expenses over the next few years, attention can shift to potentially reducing the tax burden on his heirs. *Based on his age and account balance, the client would have an RMD of $87,336.24 in the year he turns 78. Assuming he receives $3,345 of social security income monthly, he falls into the 24% tax bracket, with $127,476.24 in annual income. This leaves him with a cushion of $42,574.76 before his additional income is pushed into the 32% tax bracket. By converting that $42,574.76 of his existing IRA to a Roth IRA and paying the taxes now in the 24% bracket vs when his daughter withdrawing in the 32% bracket, allows them to save $3,405.08 each year he completes a conversion. This technique, known as "filling the bracket", lets him maximize the benefit of being in the 24% tax bracket, and allows the assets to remain in the Roth IRA during the remainder of his lifetime. It also maintains his daughter’s ability to keep the funds in the tax-advantaged Roth IRA account for an additional 10 years after his death. Since taxes have already been paid on the Roth IRA, his daughter can leave the funds in the Roth IRA, and withdraw the full amount in the 10th year, without any concerns for the tax implications. These generational transfer strategies are something to think about as clients age. Given that taxable accounts allow the beneficiaries a step up in cost basis upon the death of the client, it may be time to rethink the conventional wisdom of withdrawing from taxable accounts before withdrawing from tax advantaged accounts in retirement, especially near the end of a client's life.

This is not intended to be personalized financial advice. Always consult a financial advisor or tax professional prior to making any investment decisions or tax decisions.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

This material contains only general descriptions and is not a solicitation to sell any insurance product of security, nor is it intended as financial or tax advice.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

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