Converting IRA to Roth for beneficiaries?

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Converting IRA to Roth for beneficiaries?

Postby RonF » Sat Dec 22, 2012 12:05 am

My wife and I are retired. Our combined income from pensions is approximately $150k. We both have IRAs (formerly tax deferred 401ks) but we have no need to touch those funds. I am now taking required minimum distributions and my wife will be in a few years. The minimum distributions put our total income at just over $170k.

We are both in good health and expect to live for a long time yet. Since the minimum distributions put us in the $170-214k Medicare Part B tier, is there any reason not to convert $43k per year of my IRA to a Roth? I understand this will be a taxable event at the 28% level (federal), and I would use a portion of the annual RMD to pay the taxes. Our children have incomes that put them in the 28% tax bracket, but they will be in a much lower bracket at retirement (no pensions).

Does this approach make sense? Are there other considerations that I should be aware of?
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Re: Converting IRA to Roth for beneficiaries?

Postby kaneohe » Sat Dec 22, 2012 12:15 pm

Interesting question......don't have the answer but by replying, this will be bumped up to the top and Alan S. will get another shot at it.........just some thoughts/comments"

Be sure you take the RMDs each yr before doing any Roth conversion.

Generally the Roth conversion is considered beneficial if you do it at a conversion tax rate equal to or lower than the tax rate that would be the withdrawal rate later and pay the tax from other funds........so if you convert at 28% and your kids would inherit the TIRA (if not converted) at 28%, the conversion would be an OK thing to do. If the kids would inherit at a lower tax rate, converting might not be so great........got a crystal ball as to which case it will be? Of course, if you didn't convert you would be depleting the TIRA gradually each yr, so would you be growing it faster than it's depleting?

Be careful calculating that Roth conversion amount.....$1 too much if it pushes you into the next Medicare rate bracket would increase your premiums by about 1.8K ?/yr. I know you picked 43K on purpose but can you predict the rest of your income accurately.....perhaps you can.

Tax rates can change in future.
Last edited by kaneohe on Sat Dec 22, 2012 12:46 pm, edited 1 time in total.
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Re: Converting IRA to Roth for beneficiaries?

Postby sscritic » Sat Dec 22, 2012 12:25 pm

kaneohe wrote:Be sure you take the RMDs each yr before doing any Roth conversion.

Wife isn't RMD yet; this is a problem for husband only. Before and any could be interpreted very strictly by some - like me maybe? :)
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Re: Converting IRA to Roth for beneficiaries?

Postby kaneohe » Sat Dec 22, 2012 12:34 pm

Yes, lazy/sloppy writing.....thinking 3 yrs ahead when both are. Till then, only 1 meant............thanks for clarifying.
I should have thrown in that IRMAA term to show how sophisticated I've become since I saw you use it a few days ago :D
btw.....liked your nose & face story..........
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Re: Converting IRA to Roth for beneficiaries?

Postby RonF » Sat Dec 22, 2012 1:15 pm

kaneohe wrote:Yes, lazy/sloppy writing.....thinking 3 yrs ahead when both are. Till then, only 1 meant............thanks for clarifying.

Thanks for your thoughts.

My wife will have to take her RMDs in three years. She has a larger IRA balance, so those RMDs will push us over $200k/year if I do nothing but take my RMDs in the next three years. At that point, there would be very little extra that we could withdraw/convert before hitting the next Medicare Part B tier and the 33% tax bracket. If one of us were to die, than the other would be pushed very close to the 33% bracket ($175-180k single filer) by the RMDs.

Our kids are in their 30s but probably have another 25-30 years until retirement, given they have a much higher cost of living (mortgage, DC area, etc.) and no pensions. I expect we'll be around a long time, but probably not that long.
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Re: Converting IRA to Roth for beneficiaries?

Postby RonF » Fri Dec 28, 2012 3:18 am

Any other thoughts on this? Does it make sense to use RMDs to fund the conversion of a TIRA to a Roth over time?
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Re: Converting IRA to Roth for beneficiaries?

Postby Bob's not my name » Fri Dec 28, 2012 7:39 am

These are the advantages of converting:
  • RMDs are reduced, preserving the IRA for inheritance.
  • If you pay the taxes due out of taxable funds, you increase the effective size of the inherited IRA.
  • Paying the income taxes may usefully reduce the size of the estate. This is particularly valuable if you live in one of the states with an estate tax and a low exclusion, e.g., Maryland has a $1M exclusion and a 16% estate tax, and some states are worse than that on both points. When considering state estate taxes, take into account the possibility of moving states. This is typically unthinkable to younger retirees, but if you live in Kansas and your kids are all in Maryland and one of you dies, the other may want or need to move to the kids' state.
  • You might pay a lower tax rate on the conversion vs. the average rate the heirs will pay on distributions. This doesn't seem likely in your case, but here are some factors you may not have considered: (1) a few states (Illinois, for example) don't tax IRA conversions or withdrawals. MD and VA do, but your children might retire elsewhere. (2) You mention the 33% bracket but that kicks in at about $240,000 gross income. Maybe you're overstating your tax rate? (3) Next year the 28% bracket becomes 31% and the 33% bracket becomes 36%. (4) Notwithstanding your high pension income, it's possible you could drop into the 0% bracket late in life if both of you require assisted living. This, combined with other medical expenses, could cost you $250,000/year in deductible expenses. At that point you can convert your IRA at zero tax cost.
You see that there are pros and cons to converting a portion now.

Other things to think about are whether your kids are maxing their own retirement accounts now, and how you might contribute to your grandchildren's college educations.
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Re: Converting IRA to Roth for beneficiaries?

Postby Peter Foley » Fri Dec 28, 2012 12:41 pm

If your taxes don't go up too much, I think converting might be beneficial. Take a look at the Optional Retirement Planner at www.i-orp.com and get an idea as to what the effect of a Roth conversion would be. I also agree that depending on the size of your estate, converting to a Roth and paying income taxes prior to your wife's RMDs might be less of a tax bite than a combined state and federal estate tax.
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Re: Converting IRA to Roth for beneficiaries?

Postby bsteiner » Sat Dec 29, 2012 10:17 pm

The Roth conversion generally makes sense if the tax rate on the conversion is less than, the same as, or not too much higher than the tax rate that you or your beneficiaries would otherwise pay when you or they would otherwise take distributions.

This can be illustrated by a simple example, assuming a constant 30% tax bracket. You have a $100 traditional IRA and $30 of other money. You convert and use the $30 of other money to pay the tax. You now have a $100 Roth IRA. Over some period of time, it grows to $200, which you or your beneficiaries withdraw tax-free. Your twin brother has a $100 traditional IRA and $30 of other money, but does not convert. Over the same period of time, his $100 traditional IRA grows to $200. He or his beneficairies withdraw the $200, pay $60 of income tax, and have $140 left. However, his $30 taxable account will grow to something less than $60, since he has to pay tax on the income and gains each year.

Other benefits of the Roth conversion include no required distributions at 70 1/2 (this is a significant benefit), avoiding the double tax problem with respect to state estate taxes that Bob's not my name referred to (discussed below), a Roth is a more valuable asset to fund a credit shelter or GST exempt disposition, and a Roth avoids the compressed income tax brackets for trusts (discussed below).

There is an income tax deduction for the estate tax on IRAs, at the marginal rate. This puts you in about the same position as if you had paid the income tax first and then paid estate tax on the amount remaining after income tax. However, the deduction is only available for the Federal estate tax, not the state estate tax. This is relevant in states that have a state estate tax. (If Congress does nothing, the state death tax will be a credit rather than a deduction once again beginning in 2013, so the state estate tax will return in every state.)

We have our clients provide for their children in trust rather than outright, to keep the inheritance out of the children's estates, and to protect against the children's creditors, including spouses. The same reasons for leaving other assets in trust apply to IRAs. However, trusts reach the top income tax bracket quickly (35% on taxable income over $11,650 in 2012). There's often a tradeoff between distributing income (taxed to the beneficiaries, often at a lower rate, but this gives up the creditor protection and throws the money into the beneficiaries' estates) and retaining the income (preserves creditor protection and estate tax sheltering, but often taxed at a higher rate). A Roth IRA avoids the tradeoff.

While each case is different, many people do what was suggested here, namely converting each year the amount they can convert while staying in a particular tax bracket.
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Re: Converting IRA to Roth for beneficiaries?

Postby Watty » Sun Dec 30, 2012 1:42 am

I understand this will be a taxable event at the 28% level (federal), and I would use a portion of the annual RMD to pay the taxes. Our children have incomes that put them in the 28% tax bracket, but they will be in a much lower bracket at retirement (no pensions).

Does this approach make sense?


Unless I am missing something it does not make a lot of sense to me.

To me it looks like you will be paying the 28% tax rate to do the conversion now but the kids will be in a lower tax bracket when they retire.

If you were going to pay $10K in taxes to do the conversion today, an alternative would be to buy $10K of a total stock market ETF instead. Years from now the kids would inherit that ETF at a stepped up cost basis(under the current laws at least) and not have to pay any capital gains taxes on it. They could use that money to pay any taxes on the inherited IRA withdrawls, which would be at the a lower tax rate after they retire.

Are there other considerations that I should be aware of?


You also need to look at your numbers and tax rates as if either you or your wife survies the other by a long time. This could change the numbers a lot depending if both pensions continue or not and the tax brackets once the single filing tax brackets are used.

There are also likely a lot of estate planning issues so you should have professional advice on these.
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Re: Converting IRA to Roth for beneficiaries?

Postby SGM » Sun Dec 30, 2012 11:57 am

I have been converting to Roth IRAs over the last 3 years paying taxes out of taxable assets to expand our non-taxable assets. Several years ago I bought two books by James Lange concerning IRAs and conversions including "The Roth Revolution". I believe e books are available for free on his paytaxeslater website. Unfortunately, I do not presently have the time to review the issues you bring up.

An alternative I have heard about is purchasing a second to die insurance policy, making the children or a trust the recipient. The RMDs could be used to pay for the insurance policy premiums. This was recommended by Ray Lucia on his radio show. This is an idea that I have heard about for some time, but never really looked into it. For one thing, I consider the possibility that one spouse makes payments and the surviving spouse stops making payments defeating the purpose of the second to die insurance. It may be a good alternative for some.
"Let us endeavor, so to live, that when we die, even the undertaker will be sorry." Mark Twain
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Re: Converting IRA to Roth for beneficiaries?

Postby staythecourse » Sun Dec 30, 2012 12:42 pm

My feeling is the biggest adv. of Roth ira is: 1. No RMD for the owners and 2. No federal taxes to the heirs. So, if you are one who is unlikely to need that money in your lifetime (I would assume with your retirment income you probably fit into that category) then I would have made this move yesterday if you want any inheritance to go to your kids.

I have ALL my tax deferred in roth's if I can (no roth 401k at work unfortunately) as I am not expecting to need to ever spend this money in mine or my wife's lifetime. This is as good of a gift as you can give as an inheritance wrapper.

Good luck.
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Re: Converting IRA to Roth for beneficiaries?

Postby bsteiner » Sun Dec 30, 2012 2:58 pm

In response to SGM: life insurance, whether on one life or second to die, lets you hedge against the risk of dying substantially before life expectancy. However, if you live close to, to, or beyond life expectancy, you'll be better off not buying the insurance, assuming reasonable investment returns. You've correctly pointed out one of the issues with second to die insurance -- after the first spouse dies, the surviving spouse might not want to continue the insurance. Also, if you're retired, while it's not a pleasant thought, your children may be better off if you die early so they get their inheritance sooner. Finally, since your children will receive their inheritance at your death, while you're alive they might prefer that their gifts be in the form of cash that they can use now, rather than in the form of insurance premiums that will provide money for them at your death.

On the other hand, for someone who has a taxable estate and won't make cash gifts but would be willing to buy insurance and pay the premiums, having the children, or a trust for the benefit of the children, own the policy, and paying the premiums, can be a good way to shift money out of your estate.

Also, if you have an illiquid estate, insurance will provide the liquidity at the moment it's needed.
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