Roth IRA Conversion - For Generations

Written and edited by Harry Rubins for his clients and friends.
Not intended as legal or tax advice.
Obtain professional advice before taking action on this information.

The financial profession has missed the boat for Roth conversions by focusing only on the current IRA owner and an all or nothing decision to convert. The media, financial press, mutual funds and, yes, even financial planners and CPAs have generally overlooked the potential of using the Roth IRA Conversion for estate planning.

Most of the examples I have seen illustrated in the media and in mutual fund or financial planning software require a decision that either 100% or none of the IRA is convertible to a Roth based solely on a 20 year retirement to age 85. Little thought seems to have been given to the possibility that a partial conversion might be beneficial, that people live longer than 85, and that most IRAs are inherited by the next generation.

Compounding the problem, according to David Cay Johnson’s 6/7/98 New York Times article, is that the same set of facts can generate different conclusions in different software programs. Predicting tax rates in the future or what a marginal tax rate might be with changing life styles is an almost impossible task. Thus, the decision process to convert often becomes entangled in the many complex, uncontrollable variables and the opportunity for conversion is missed.

Multi-generational benefits clarify the conversion decision

When the Roth Conversion is seen as a long term multi-generational planning opportunity, the decision is greatly simplified. It’s no longer a yes or no decision with complex assumptions that confuse the issue but "How much can I afford to convert" to benefit two generations. The 20 year retirement benefit expands to 60 or 80 years of "tax freedom" for the account owner and heirs. What a great gift to pass on.

So let’s take another look at the Roth IRA Conversion.

What Is A Roth Conversion?

The Roth IRA conversion is a process that transfers taxable IRA & SEP IRA accounts into tax free Roth IRA accounts. Sorry – no direct transfers from 401(k), profit sharing, 403(b), etc. to a Roth IRA. These assets must first transfer to an IRA Rollover account before conversion.

The initial advantage is that these converted assets will be income tax free & penalty free after a 5 year hold period for account owners of any age. The accumulated earnings inside the Roth also become income tax free and penalty free after age 59 ½. Qualifying distributions such as withdrawals for college expenses and $10,000 for first time home buyers are tax free at any age.

Converting to a Roth IRA creates a valuable income tax & penalty free investment account that adds a new dimension to tax, financial & estate planning strategies.

The Roth conversion is limited to single individuals and married couples filing jointly with an adjusted gross income (AGI) of $100,000 or less (married filing separately, only $10,000 AGI). Unfortunately, this eliminates many high income earners who could greatly benefit from a conversion. The converted taxable assets are not counted in determining the AGI limit and the income taxes due can be paid entirely in the year converted. There is no limit on the amount that can be converted or an age restriction because the normal 10% early withdrawal penalty is waived. If the income taxes are paid from non-IRA assets, the new Roth account will have the same value as the original IRA ($100,000 in the IRA becomes $100,000 in the tax free Roth).

The general criteria for considering a full or partial Roth conversion are:

• Ability to pay income taxes with non-IRA assets, and
• No need for distributions during the 5 year hold period.

Future tax rates and how old the IRA owner is when the conversion takes place are less important criteria in multi-generational planning. However, Roth conversions for 30 or 40 year old IRA account holders usually make sense because they have more time to make it work during their lifetimes.

No Age 70 1/2 Distribution

Unlike the IRA, the Roth does not require mandatory distributions to begin at age 70 ½. The assets can keep growing tax free. The Roth does not have to deal with the complex and irrevocable decision that must be made at age 70 ½ for IRAs. A partial Roth conversion can add flexibility and eventually reduce the amount of the required minimum distribution after age 70 ½ from the taxable IRA.

A Roth conversion may also make sense for IRA holders in their 80’s who are taking RMD's.

A full or partial Roth can help by reducing or eliminating the RMD while creating income tax free assets for the next generation.

Estate Planning Opportunities

Roth accounts simplify estate planning for larger estates subject to federal estate tax and/or with complex trusts to manage children's assets. While both Roth and IRA accounts are subject to federal estate taxes, the Roth is income tax free so has none of the problems associated with income taxable IRA accounts. Using IRA account assets to pay federal estate taxes is a problem because every dollar withdrawn is taxable. To net $10,000 to pay federal estate tax requires $14,000 or more from the taxable IRA, but only $10,000 from a Roth.

Because of the taxable nature of an IRA these assets also cause problems in funding credit shelter and QTIP trusts. The problems are complex so an IRA usually ends up going entirely to the surviving spouse, which is okay if there are other non-IRA assets to fund these trusts. But many IRA accounts now have $100,000 to over a million dollars in assets, representing 30-60% of the estate. In these estates the spouse may end up with 75% of the assets rather than 50% as originally planned, resulting in loss of control by the decedent and higher estate taxes when the spouse dies a problem few are aware of that effects more estates every day. A Roth, on the other hand, can fund a more balanced estate as planned.

The Next Generation Benefits

The big payoff comes when the next generation of beneficiaries inherit the Roth account income tax free. Beneficiaries will have greater financial and tax planning flexibility when they initially inherit a $100,000 Roth tax free than they will when inheriting a $100,000 IRA that is taxable. The Roth will create greater wealth over time because the income is tax free as the example below shows.