Using a Roth IRA as a wealth planning tool

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the biggest consideration is often “what is your tax rate today versus what will the tax rate be when the proceeds are withdrawn in the future.”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.

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