Roth IRA Conversions? Better Wait and See.

iStock_000001256923XSmallFor years, it has been possible to set up your estate plan so that when you die, your heirs can stretch out the distributions from your IRAs – over their lifetime.

Many well to do families have been counting on this as a way to pass along significant wealth to their next generations. The money in the IRA can be used during your lifetime, but then can accumulate tax free while the next guy in line for it takes minimum distributions over his life. This is because the money is protected in the tax deferred (or tax free) account and it can build significantly over time.

Because traditional IRAs require the recipient of distributions to pay regular income taxes on all (if the IRA was built with pre-tax contributions) or part (if the IRA was built with after tax contributions) of the money received, many have converted from traditional to Roth in anticipation of a lower total family tax bill.

Roth IRA contributions are made post tax. The account owner does not have to take any required distributions during their lifetime and if taken, neither the distributions nor the earnings are taxed (assuming the account has been in service for at least 5 years). Contributions to a Roth IRA are limited by income and phased out at certain levels, but (as of now) anyone can convert a Traditional IRA to a Roth IRA – as long as all taxes are paid.

Because we have made too much money over the years, Congress has seen fit to limit the amount we could contribute to a Roth IRA to 0, zero, zip, nada, nothing. After retiring, being in a lower tax bracket, I converted some of the money in my traditional IRA to a Roth account, intending to leave it to the youngest family members living at the time of my death and somehow train them to take only the minimum required distribution over their (much longer) lifetime – thus stretching out the years in which the money accumulates tax free.

You have to be careful how you set up the beneficiary on these Roth accounts in order to stretch them. Some financial advisers suggest that (if you trust your spouse), it is best to put he or she as the primary beneficiary. Currently a spouse has the most flexibility, being able to even take over the IRA and treat it as his or her own (including changing the beneficiaries!). There are pitfalls to consider in leaving it to minor children too. If they are primary beneficiaries, the parents or guardians may have to go to court and get themselves designated as able to manage the account for the child. Similarly, leaving the account to a trust can lead to unexpected results. The beneficiary apparently needs to be clearly identifiable and a real person at the end of the line.

Once all those obstacles are overcome, you need to figure out how to get your heirs to honor your wishes to stretch out the distributions, instead of say, your grandson deciding to cash out and go buy that red hot Porsche. Education, threats of hauntings from beyond the grave and repeated instructions seem to be the most direct ways of handling this.

But, alas, now our wonderful elected leaders are discussing ways to ‘close this loophole’ (according to Forbes) and force heirs to take distributions from any inherited IRA within 5 years. Yikes! If you have been shucking money into your IRA religiously and it has been growing, it can be a pretty big kitty. Lets say you accumulated a couple of million in your IRA and it is there at the time of your death. Your heirs will have to take all of that out within 5 years. You do the math, but my calculator shows that is $400K a year.

There are two problems with that in my mind.

First, if I had managed to convert everything to a Roth, the grandkids would be swamped with hundreds of thousands of dollars a year. Not my intent for sure as I don’t want excess amounts of available cash to ruin their lives.

Second, if I didn’t have it converted, the tax bill each year will be horrendous for them, because it would be now and I sure don’t see tax rates going down with the national debt being 15+ TRILLION dollars. That money has to come from somewhere and unfortunately we all just keep kicking it down the road to my grandchildren.

I have one more lower tax year and then will start collecting some pensions that will up our income (darn the luck), and so was planning on doing some more IRA converting next year. Now I am going to wait and see what Congress ends up doing.

I know that most folks don’t take a generational view of wealth management, and that it is somehow frowned upon by Americans, but I want my kids and grandkids to have a leg up and if I can help with that, I intend to do so. However, it sounds like using a stretch Roth IRA won’t be a way to do it so it’s back to the drawing board for me.

What are your thoughts on stretching out IRA distributions for heirs?


Roth IRA Conversions? Better Wait and See. — 5 Comments

  1. Generational wealth is something that fascinates me and this post is helpful in how my husband and I will plan to save. We use two different Roths right now just because we’re in a low bracket and want all those advantages. I wonder what happens if your heirs choose not to take the income? Can a back up plan be worked in?

    • Although I’m no expert, the way I understand it is that heirs have to take required distributions from the inherited Roth account – but currently they can take them over their (presumable much longer) life spans, instead of really fast in the 5 years following the death of the owner. If they don’t take the money, the IRS will penalize them.

  2. I would still convert to Roth over time. Even if the law is changed and the RMD for heirs will have to be done over just 5 years, at least they will not be hit a a really big tax bill. You will hopefully have the luxury of converting over much longer than 5 years, knock on wood, so you can keep your marginal tax rate much lower. And if they do not have to pay taxes on the RMDs, perhaps they will be more inclined to reinvest the money in a taxable account, or make sure their retirement savings are fully funded. Just be sure you continue with your heir’s “education, threats of hauntings from beyond the grave and repeated instructions.”

    • All true, the tax bite on a traditional IRA can be hefty for inheritors. After all, it counts as regular income to them, plus, they may have to cough up for estate taxes (not for us though, we aren’t that rich! – the limit per person now is 5 million before your heirs have to pay estate taxes)

  3. I have started working with an estate planner to learn the ins and outs of generational wealth. I will report back once I learn more and set up a long term plan. I am looking to real estate and business structuring as my legacy plan to pass assets from generation to generation but it’s not an easy topic especially when the tax rules are always so dynamic. Like you said, with the $15 trillion plus in debt there’s likely lots of changes coming…

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