Roth conversions remain one of the most underutilized tax planning strategies around.
Imagine the limited benefits of continued tax deferral for a 90-year-old retiree with a $500,000 IRA and an income of $100,000 a year. That income is comprised of pension distributions, IRA required minimum distributions (RMD), and some dividend income. Let’s say she has two grown children in their 60s, each earning $600,000 a year in a 41% tax bracket. Since Mom’s tax bracket peaks at 24% (up to around $170,000 worth of annual income), it would make perfect sense for her to do annual $70,000 Roth conversions, whittling down her $500,000 IRA and avoiding that next bracket of 32% above $170,000 in gross income.
Under current rules, children who inherit their parent’s IRAs are forced to withdraw the entire balance within 10 years of passing. Non-spousal inheritors must also maintain the decedent’s RMD’s, thus accelerating the taxability to the next generation. Unless the children’s tax brackets somehow get cut in half in the near future by way of their own retirement or other factors, the family would be far better off to have paid the tax in Mom’s bracket while she is alive. Roth conversions are one way to accomplish this.
One drawback is that Roths must be emptied even sooner after death, with a five-year life in this example. Yet, that’s five more years of tax-free compounding, and the net will be increased by the 17 points of lower taxes for Mom’s conversions versus the kids’ tax brackets. Roths also have no RMD requirement for the inheritors, so the five-year difference in depletion is not as stark as it might appear. One risk is that while Mom can also access the Roth for income if she finds herself living even longer than she imagined, there is a five-year “leave alone” period on each conversion. Mom’s withdrawals inside the five-year period are tax-free but would have a 10% penalty.
Unless the children are on the cusp of retirement themselves and might then have a significant cut in income tax rate prior to the 10-year depletion clock period on the inherited IRA, the IRS is the likely loser in this example. Not surprisingly, I can live with that.
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