In my last article, I wrote about how billionaire Peter Theil turned an initial $2,000 contribution to his Roth IRA into $5 billion (available to him tax free), and how most Americans can take advantage of this type of arrangement if they have earned income.
But there are also advantages for people who may be above the income limits set by the government, and who don’t qualify to directly contribute to a Roth IRA. One possible way is by using a strategy known as a Roth Conversion. In other words, converting all or a portion of an existing Traditional IRA into a Roth IRA.
Roth Conversions and Estate Planning
By far, the biggest advantage of Roth IRA’s is the ability for your money to potentially grow tax-deferred, and then to be withdrawn tax-free after 59½, or prior to the account being opened for 5 years, whichever is later. But unlike a Traditional IRA, they don’t have to be withdrawn at all during your lifetime. In other words, you won’t be forced to take Required Minimum Distributions at age 72.
Traditional IRAs are meant to be emptied by the time you reach approximately age 100, so you must begin taking distributions – called RMD’s - after reaching age 72 whether you need the money or not. But with a Roth IRA there are no such requirements.
This can be an important advantage, especially if you don’t need the money and plan to pass it on anyway. For example, if you lived to age 90, this would give the full account 18 more years to compound. Keep in mind, I’m only using the age of 72 (and 18 additional years) to highlight the advantages. The earlier the conversion, the more time there is to potentially grow the account and the greater the tax savings. Many people begin converting IRA’s they feel they won’t need in their early 60’s.
Also, if your non-spouse heirs are in a higher tax bracket that you, this would potentially save them a considerable amount in taxes when they inherit the account
The Tax Hit
We know the government isn’t going to let us do something like this without some pain. So, by converting a Traditional IRA into a Roth IRA, you essentially forfeit the tax deduction benefits your received when you contributed and/or rolled over the money to the IRA. As a result, you’ll owe taxes on your original contributions and the growth (neither of which have ever been taxed).
But you’ll receive the benefits of the Roths tax-deferred growth potential going forward, along with income tax-free withdrawals at some time in the future – either when you or your heirs take distributions from the account. The farther out that future is, the more advantageous this strategy becomes.
If the account is inherited by your spouse, he or she can either leave it in the deceased spouses name or change the ownership to their own. At that point, it’s theirs and the benefits continue until their death.
When a non-spouse heir inherits either a Traditional or a Roth IRA, they must begin taking Required Minimum Distributions almost immediately and were able to stretch their required distributions out over their life expectancy. But they lost a substantial benefit in the SECURE Act last January. Now, the account must be emptied within 5 years. While that’s an obvious take back by the government, if they inherited a Roth IRA, at least the forced distributions over 5 years would be income tax-free.
Key Considerations
Since what you’re essentially doing is pre-paying the taxes on these accounts, the question is, does this make sense. Besides the mathematical equation that will help answer that question, there are other considerations.
- First, do you have assets in IRAs you likely won’t need in retirement?
- Do you plan to leave anything to non-spouse heirs?
- Do you expect your non-spouse heirs to be in higher tax brackets than you in the future?
- Do you have the money to cover the tax liability?
If you feel this might be right for you, a qualified financial advisor should be able to run the calculations and provide the guidance you need.
And remember, do you want to pay taxes on the seed, or the crop?
Michael P Henderson, CFP® CKA®
Founder | CERTIFIED FINANCIAL PLANNER™
Crossover Point Advisors
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific situation with a qualified tax advisor.
All investing involves risk including loss of principal. Unqualified Roth withdrawals may result in a 10% IRS penalty
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Crossover Point Advisors, an SEC Registered Investment Advisor and