Rebecca Katz: Our first question is from Nicholas in Florence, Alabama. Thanks for the question. “If we are in upper income brackets and never plan to use all of our IRA money, is it prudent to convert to a Roth, to then be passed on as an inheritance?” So, Joel, we were going to come to you first. I owe you anyway, since I butchered your name.

Joel Dickson: Usually when we talk about the potential value of a Roth IRA conversion, first and foremost, the biggest consideration is often “what is your tax rate today versus what will the tax rate be when the proceeds are withdrawn in the future.” If you think it’s going to be higher in the future than where you are currently today, you might think about having more Roth IRA assets, because you’re basically trading the lower tax rate today for avoidance of a higher tax rate in the future. That’s kind of the basic discussion that we would have.

But if we take that a step further and think about more sophisticated or more complex interactions that can occur with Roth IRAs, the answer ultimately comes to a certain standpoint of “it depends in this case.” Because if you’re in a high income bracket, and you’re going to stay there, and your heirs might have a lower tax rate, normally you would think, “Well, maybe a Roth IRA conversion isn’t for me.” However, there are some other things that might come into play in that decision.

One being, for example: at age 70½, you end up having to take required minimum distributions from a traditional IRA, in essence taking money out of the tax-preferenced vehicle. Whereas with a Roth, you don’t have to take those required minimum distributions while you’re alive.

A second one would be that, if you can use taxable assets to pay the conversion tax, you are in effect sheltering more assets in a tax-deferred or a tax-preferenced vehicle, which might make some sense, even if your tax rate isn’t going to change.

And then finally, as we’ll talk about more later, if you were to do a Roth IRA conversion and you use money from your—say—a taxable account, to pay the conversion tax, it removes that money from your total estate. And for those that might be thinking about estate planning, or might be facing estate taxes, given the size of their estate, that can be one tool among many that can help reduce the size of the overall estate.

Alisa Shin: I think I would just add one thing, from an estate planner’s perspective. I think the other factor to consider is what your goals are with respect to your wealth. So, if a client is charitably inclined, it might make sense to not convert all of it but just convert a portion of it so that you can leave your traditional IRA assets to that charity. And because it’s a public charity and a tax-exempt entity, when they receive the IRA at your death, they won’t have to pay income tax on it.

Rebecca Katz: Lots of thinking that you have to do.

Alisa Shin: Exactly.

Rebecca Katz: Well, we have a very specific question around that from Craig, and he asks if you could “explain how Roth IRAs fit into estate planning, along with traditional IRAs and taxable investments. What are the pros and cons when it comes to thinking about your estate?”

Alisa Shin: Right. Well, Joel kind of hit on it in an earlier question, but just to reiterate and add a couple points. You know, I really think it’s probably in three areas. One is, again, what your goals are with respect to your estate plan. Who do you want your assets to go to? Do you have a charitable intention? If you do, a Roth IRA might not be appropriate in your plan, or maybe even just a partial conversion may be appropriate. It’s not a one-and-done deal. You don’t have to do a 100% conversion. You can do partials and you can do it over time if your goals start to change.

The second one is if you have a taxable estate. If you’re going to be subject either to federal estate or even state estate tax, converting it and paying the taxes from non-IRA assets effectively reduces your family’s overall estate tax exposure. And that’s just by way of mathematics—the nature of the estate tax, because it’s a cumulative tax, and how that’s calculated. Your family will almost always be better off if you convert and pay the income tax up-front.

Now you have to take other considerations into effect. You know, tax rate, your income tax rate today, your kids’ potential income tax rate, or if you’re going to give it to your grandchildren, what their tax rate’s going to be. So there’s a lot of different factors. There’s no—unfortunately there’s no one answer for all of our clients. You could have two clients who have the exact same net worth, same family structure, same ages, and I bet you they’re going to come to different answers to that question.

Rebecca Katz: Does it change? I mean there were recent changes in estate tax, and I guess you have to keep your eye on that in case that changes too?

Alisa Shin: Exactly, exactly. And we did. We got a new law in January that gave us what I’ll loosely call permanency, in the estate tax world, probably the first time in almost 12 years: we don’t have a sunset provision. And right now, each individual can give up to $5.25 million free of the federal estate tax. But there still are a number of states—I want to say 13 to 14 states—that have their own state estate tax. So even though your net worth might be below that [$]5.25 [million], it’s almost guaranteed that if you live in a state that has a state estate tax, you’ll be subject. Because those thresholds tend to be much lower than [$]5.25 [million].

Rebecca Katz: Did you want to add something, Maria?

Maria Bruno: If I could add to it, because I think you need to think about it in terms of estate taxes as well as income taxes. We talk a lot around tax diversification on the planning side, when you’re saving for retirement—tax diversification by having traditional, Roth, taxable accounts, gives you a lot of flexibility when you’re withdrawing assets. Similarly with estate planning, so if you have different types of accounts, you can perhaps strategically think about beneficiary planning, wealth transfer. It just adds more to it, I think.

Alisa Shin: Absolutely.

Rebecca Katz: We have a follow-up question. Joe from West Bloomfield, Michigan, says,”Is there any drawback to designating my grandchildren as opposed to my children as Roth beneficiaries?” It sounds like we’ve talked about some of the advantages, if you’re talking about a much longer time horizon; are there any drawbacks?

Alisa Shin: I think one factor is whether or not your children need the money. Are you disinheriting them because there’s a reason that you’re doing so, or you’re giving other assets? Some people assume that because they might give it to the grandchildren, the grandchildren will take care of the parent if the parent really needs the money. I always think that’s a little risky. One would hope, but you never know.

I would want to make sure that the grandchildren truly are the intended beneficiaries of it. And just going on the softer side of the planning, is really thinking through—depending on how old the grandkids are now—what kind of sense you have, what kind of people they are, how they manage money, how their decision making skills are. If something happens to you prematurely and they receive a Roth IRA that’s a large amount, it could have negative consequences that are not intended.

So if you are considering that, I would really encourage you, if you’re comfortable, to make sure that you’re talking with your kids, so that you can coordinate your planning with your children’s planning to ensure that everyone is on the same page and there’s no surprises at the end of the day.

Rebecca Katz: Conversation—it sounds like a lot of this comes down to having conversations and being thoughtful about what your intentions really mean.

Joel Dickson: I think we can generalize that discussion even a little bit more. Which is to say, beneficiary designations generally are extremely important and can affect plans. For example, there’s a lifetime unlimited spousal estate tax benefit. So if you start then going to different beneficiary designations, you might trigger estate tax if it’s not a well-crafted plan. So there are lots of things to think about with beneficiary designations.

Important information

All investing is subject to risk, including the possible loss of the money you invest.

Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.

This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.

© 2013 The Vanguard Group, Inc. All rights reserved.

Disclaimer: Please note that the Tax Cuts and Jobs Act of 2017 removed the ability for taxpayers to do any “recharacterizations” of Roth IRA conversions after 12/31/2017. The material below was created and published prior the passage of the Tax Cuts and Jobs Act of 2017. 

Rebecca Katz: We just got this great question in that I was going to ask you myself if nobody else did. This is from George in North Carolina, so thank you, George. “Please explain Roth re-characterization.” Is this the “oopsie, I converted and I shouldn’t have done that”?

Maria Bruno: Yes, but it’s not always an oopsie. It could be a very viable strategy that someone is employing. Actually we’re having these conversations right now because at the end of last year there was a lot of uncertainty around what would happen with 2013 tax rates. So some investors actually decided they would convert, and then maybe decide to re-characterize later. So what a re-characterization is is it’s really almost a mulligan; the IRS lets us do a do-over. So if you convert to a Roth IRA or even if you contribute to a Roth IRA and then decide that you want to reverse that, the IRS allows you to do that.

Now there are some stipulations; there’s holding period requirements. So if you converted last year, for instance, and you want to re-characterize this year, you have until essentially October 15 to do that. So it’s a tax filing deadline or a tax extension.

So you can convert them. Basically what it does is it takes whatever—whether it’s a partial re-characterization or a full re-characterization—brings that back into a traditional IRA. So any earnings or losses would be carried back over into that traditional IRA. The end result is as if the conversion never happened or the Roth contribution never happened.

Joel Dickson: Where this can be valuable is, for example, although this is not as likely this year—given that we’ve had pretty robust financial market returns—but let’s take that $100,000 that we had been talking about earlier and you converted that from a traditional to a Roth IRA. Let’s assume that it was fully taxable, so it was all $100,000 of pre-tax dollars.

If the investment that you put it into in the Roth IRA were to have gone from $100,000 to $80,000, that is, declined 20%, sort of go “Well, why should I pay taxes on $100,000 when right now the account is worth $80,000?” So re-characterizing back to the traditional IRA where now you have $80,000—and then once you get over the certain requirements to then do a reconversion, which basically is either 30 days following the re-characterization or the next tax year—it sort of depends on where you are in the tax cycle. You would now just reconvert $80,000 and pay tax on $80,000, instead of paying tax on $100,000 if you wouldn’t have re-characterized.

Rebecca Katz: Assuming the markets didn’t go back up.

Maria Bruno: There’s holding periods. So you’re kind of at the mercy of the markets, almost, depending on how you’re invested. You can actually put the monies back into the traditional IRA and keep it there or you can actually reconvert after the holding period expires.

Joel Dickson: One of the things that I do think we have to be careful about in 2013—because as Maria mentioned there was a lot of uncertainty about tax rates, we have the fiscal cliff, all that kind of stuff—for some people tax rates increased in 2013 from where they were in 2012, either through all of the deductions changing, or through the Medicare, or through ordinary income tax rates. So even if the account went down in terms of the value of the conversion from a traditional to a Roth, it might not make sense to re-characterize, because now you would be reconverting in 2013 or 2014 at potentially higher tax rates. So what matters is the total tax bill, not so much the amount in the account.

Important information

All investing is subject to risk, including the possible loss of the money you invest.

Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.

This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.

© 2013 The Vanguard Group, Inc. All rights reserved.

Rebecca Katz: We have another question from Charles in Houston, Texas, who says, “In retirement, should my Roth be managed? Should I continue funding it in retirement, start withdrawing before or after taxable and tax-deferred accounts?” We promised to talk about managing retirement income using a Roth. Is there a good approach here? And if he’s retired, I assume he has no earned income and therefore can’t contribute?

Maria Bruno: So you can’t contribute unless you have earned income. If you’re taking distributions by having the different account types, you can strategically manage that on a year-by-year basis. So the previous individual who was in a low tax bracket, for instance, may be considering a conversion. Well, if you’re withdrawing and you may be in a very low tax bracket, then you typically would—for whatever reason in a particular year—then maybe you would want to draw from tax-deferred that year and not Roth.

Generally speaking, the more you can let the Roth grow tax-free, generally the better off— because that account gets to grow and you don’t necessarily need to take the RMDs and what-not. But assuming that you don’t have RMDs from the traditional IRA, you’re usually faced with the “where do I spend from” and generally if you have taxable assets—because those are taxed at lower rates, capital gains rates are taxed lower than income tax rates, and you might have some losses and things like that you can manage in taxable accounts—that’s usually the first source of spending. Beyond that, then you want to look at what your current tax rate is versus future tax rate expectations.

Joel Dickson: And tax rates can change quite a bit in retirement. I mean, think if you have large medical expenses one year. So you might have much higher itemized deductions, for example. Well, there your tax rate is a little bit lower than normally where it would be. And so there you might want to take distributions from the traditional IRA, because it won’t be as heavily taxed. Whereas in other years maybe you have a higher income, and so to the extent that you need resources from a retirement income standpoint, you take it from the Roth.

Alisa Shin: This is where I risk getting kicked under the table by my investment colleagues here. From an estate planner’s perspective, obviously depending upon what your overall taxable estate is, what your net worth is, if you are subject to federal or state estate tax—if you are, from an estate planner’s perspective, it is generally better to leave what I’ll call taxable assets, non-IRA assets, to your individual beneficiaries than it is to give a traditional IRA. Just because that IRA will be subject to both the state tax and income tax as your beneficiary takes it out, especially if your beneficiary will be in a higher tax bracket than you are currently in. It might be even more important for you to spend down from your traditional IRA.

Where I usually end up compromising with my colleagues here, which came about in 2010, was to say if you don’t want to spend down your traditional IRA, at least convert that amount into a Roth IRA and we get almost the best of both worlds.

Maria Bruno: I think what we’re really getting to here is that there’s an interplay between income taxes and estate taxes, depending upon how large your net worth is. And if you’re in that situation and you want to pass assets to your heirs or charities or whatnot, then you really probably want to sit down with a professional and talk about it. Because you do want to maximize the wealth transfer, minimize the current taxes as much as possible. But there is a big interplay between income taxes and estate taxes.

Joel Dickson: There’s just big interplays all over the place here. I actually worry we’ve given the impression that in the year of Roth conversion, you’re always going to have induced even higher taxes. Yes, you have to pay the tax on the conversion. We talked about deductions and exemptions and so forth. But even there, there are actually potential offsets, because if you have more income you might have less alternative minimum tax. So you might not be paying the full freight of the marginal income tax rate.

Or it might raise your charitable deduction cap. Because you have more AGI, adjusted gross income, you can actually give more to charity if you’re a big charitable giver in those years. So one strategy is actually to pair large charitable giving with Roth IRA conversions. So there are lots and lots of nuances to this.

Rebecca Katz: Sounds like you need both the estate planning attorney and a good accountant.

Important information

All investing is subject to risk, including the possible loss of the money you invest.

Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.

This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.

© 2013 The Vanguard Group, Inc. All rights reserved.