Why a Roth Conversion Is a Powerful Estate Planning Tool

Under the Secure Act, Roth IRAs allow beneficiaries to enjoy 10 years of tax-free account growth.

Prior to 2020, leaving a traditional IRA to young beneficiaries provided dual tax breaks: The original owner reduced taxable income by making pretax contributions during life, and the beneficiaries were able to stretch the benefits of tax deferral over a lifetime.

Under the Setting Every Community Up for Retirement Enhancement (Secure) Act, those incentives have been muted by the new 10-year distribution rule for non-eligible designated beneficiaries. On the flip side, the Secure Act changes have made Roth conversions even more appealing for clients looking to provide a tax-advantaged gift for beneficiaries upon their death.

While a Roth conversion strategy can have many different benefits for the original account owner during life, many clients overlook the potential upside for account beneficiaries after the original account owner’s death.

Inherited IRA Distribution Rules

Before the Secure Act became law, inherited IRA beneficiaries had the option of stretching distributions — and the associated tax liability — from the account over their own life expectancy. Younger beneficiaries often benefitted from decades of tax-deferred growth.

Post-Secure Act, beneficiaries who do not qualify as “eligible designated beneficiaries,” or EDBs, must empty the account within 10 years. Further, if the original owner had already begun taking required minimum distributions, the beneficiary must also take annual RMDs during the 10-year distribution period.

While the IRS has provided some relief from the annual RMD requirement for 2021 to 2023, someone who inherits a traditional IRA must now pay taxes on the entire account balance within 10 years of the original account owner’s death. That can be a sizable hit, especially if the beneficiary is in their peak earning years.

Roth Conversions and the 10-Year Rule

The Secure Act did modify the rules governing inherited Roth IRAs. Roth beneficiaries who do not quality as EDBs are now required to empty the account within the same 10-year distribution period that applies to traditional accounts.

However, Roth IRAs have a distinct advantage because Roth IRAs are not subject to any RMD rules during the original IRA owner’s life. As always, Roth IRA beneficiaries must take RMDs after the original account owner’s death.

The benefit is that the original owner will always be deemed to have died before their required beginning date. That’s because a Roth account can never go into pay status due to the fact that there is no required beginning date (i.e., because the original owner didn’t have to take lifetime RMDs in the first place).

In other words, any Roth IRA beneficiary can wait until the 10th year to empty the account and allow the funds to grow tax-free for another 10 years without worrying about the tax hit in Year 10.

When the beneficiary eventually takes distributions, the original contributions are nontaxable because the original account owner paid taxes on Roth contributions during life. If the five-year rule is satisfied (meaning that at least five years have passed since the original owner made their first contribution or conversion to the account) earnings will also be tax- and penalty-free to the beneficiaries.

Roth Conversions: The Basics

Individuals whose income exceeds the thresholds that apply to Roth IRAs cannot contribute directly to a Roth account. Instead, they must go through the “back door” by executing conversions.

The individual takes funds that were contributed pretax to a traditional IRA and executes a conversion to move the funds into a Roth account (paying taxes on the amounts converted at the individual’s ordinary income tax rate).

Assuming the owner leaves the funds in the Roth vehicle for at least five years, both the amounts converted and earnings on those amounts can be withdrawn tax-free.

There are ways to minimize the sting of current taxation that deters some clients from executing Roth conversions. Some clients prefer to convert small amounts over many years to fund their Roth accounts.

Others wait until they have stopped working, so they are in a lower tax bracket. However, with the Trump-era tax cuts for high-income taxpayers currently in effect, clients should pay attention to proposed future tax hikes to make the most of their Roth conversions.

Conclusion

Roth accounts are extremely beneficial to the person who funds the account because they offer a tax-free source of income during retirement. However, Roth accounts also provide a valuable tax-free gift for account beneficiaries.

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