As you create or update your estate plan, you might consider using Roth conversions to minimize the tax hit your heirs will take. Tax law changes both past and future make this strategy more and more attractive.
Read on to learn about the changes and how a Roth conversion may help you make a more impactful gift to your children, grandchildren, and other loved ones.
Tax and Estate Plan Changes
Until recently, you could leave an IRA to your heirs, and they’d have the rest of their lives to make withdrawals from it. This long timeline allowed them to take advantage of investment growth and enjoy some tax flexibility.
However, the SECURE Act of 2019 eliminated this so-called “stretch IRA” for most beneficiaries. Now, if you leave a traditional IRA to your adult child, for example, they must empty out the account within 10 years.
This rule reduces the impact of your gift. Your heirs must pay taxes on the distributions, and the income could bump them into a higher tax bracket.
As for tax brackets, the Tax Cuts and Jobs Act in 2017 lowered tax rates—but only temporarily. Unless Congress acts, the tax brackets will revert in 2026.
Given our country’s jaw-dropping deficit, it’s also reasonable to assume taxes will increase at some point.
And finally, President Biden has proposed eliminating the step-up in basis for inheritances.
All this means that Uncle Sam stands to take an even larger bite out of the legacy you leave to your loved ones, which is why you should consider the suitability of a Roth IRA conversion.
How a Roth IRA Conversion Can Benefit Your Estate Plan
A Roth IRA works differently from the traditional IRA. With a traditional individual retirement account, you don’t pay taxes until you withdraw money from the plan. But with a Roth IRA, you pay taxes upfront, your contributions enjoy tax-free growth, and your distributions are generally tax-free.
Similarly, you pay taxes at the point you convert a traditional IRA into a Roth IRA. So, when that Roth account becomes part of your estate plan, you have essentially covered the tax bill your heirs would have received.
What’s more, in paying taxes, you have reduced your estate value, potentially reducing estate taxes.
Note that tax-free withdrawals begin only after five years have passed from the date of the conversion. So if you were to die, say, three years after making a Roth conversion that you leave to your daughter, she may have to pay taxes if she makes withdrawals within the first two years of inheriting it.
We say “may” because only the earnings are taxable. The original conversion amount has already been taxed. If your daughter withdrew only from the contribution you made, she would likely avoid taxes.
Roth conversions are best made in years where you have lower income or more deductions to offset the taxes you pay. You also need to have the cash on hand to pay the taxes.
You may want to work with a fiduciary financial advisor to determine a long-term strategy of conversions based on your current and future financial situation. Your advisor can also collaborate with your estate planning attorney and CPA to provide the updated financials they need and to help ensure no details slip through the cracks.
Final Thoughts
No one can predict whether and when taxes will increase. However, the government will have to pay for the deficit, which generally means reducing spending or raising taxes—or both. Meanwhile, the elimination of the stretch IRA calls for creative problem-solving to help your heirs get the most out of your gift.
While your surviving spouse can stretch out a traditional IRA over their lifetime, your adult children and grandchildren, in most cases, will have to close the account within 10 years and pay taxes on the distributions. Roth IRA conversions could help your heirs keep more of their money if taxes do increase.
Schedule a complimentary consultation with one of our fee-only financial planners to discuss your personal situation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.