“Concerning a Traditional to Roth IRA Conversion, most are successful when the tax bracket is 22 percent or less, and you have not started to collect your Required Minimum Distribution yet.”
–Conventional Wisdom
“Rules are made to be broken”.
–General Douglas MacArthur
INHERITED IRAS AND THE “TAX BOMB”
In the last post, I pointed out that it is hard to use an inherited traditional IRA for retirement and to avoid the taxes associated with it.
An inherited traditional IRA is like getting a second taxable salary income for 10 years–with new taxes on the extra income as the price you bear. So, is there any way to blunt the tax impact?
There are not many.
The problem is that most people inherit at age 50-65, during their peak salary-earning years, when they often pay their highest marginal tax rates. Moreover, they cannot directly transfer the inherited IRA into a Roth and avoid some tax consequences. So, for many, the situation is not ideal.
However, as I will point out, there is an indirect way readers can use an inherited IRA to fund a Roth conversion instead. It is not a one-size-fits-all solution, but you should know about it and its pros and cons. And while it works for only a limited group of people, it may work for you.
WHY ROTH FUNDS ARE DESIRABLE:
Before we get into the analysis, keep in mind that many financial writers favor Roth IRAs for retirement. There are two primary reasons: few restrictions on the eventual withdrawal of the money for retirement, and funds compound tax-free until they are withdrawn.
Roth accounts are so flexible that many retirement experts recommend funds be withdrawn last after traditional IRAs, cash, interest, dividends, and long-term capital gains. They have the fewest taxes, deadlines, and restrictions.
So, now that you know how desirable Roth funds are, how do a Roth account and conversion work?
ROTH IRAs AND CONVERSION FROM A TRADITIONAL IRA
A Roth IRA is a retirement account that is funded with money on which you have already paid income tax. Your investments can grow tax-free. Unlike traditional IRAs, Roth IRAs have no required minimum distributions (RMDs) during the owner’s lifetime, so there is no defined time limit for taking distributions. Penalties apply in limited circumstances, such as if an owner accesses money before age 59 1/2. See here.
Contrast this with a Traditional IRA. Contributions are often tax-deductible in the year they are deposited, investments grow tax-deferred, and withdrawals are generally taxed as ordinary income. You also must start withdrawing at some point. RMDs (Required Minimum Distributions) start at age 73-75 and require you to withdraw a minimum amount each year. So, your investments don’t compound tax-free forever, and withdrawals are taxed as ordinary income.
Some people convert their traditional IRAs to a Roth to gain flexibility. In a standard traditional IRA situation, a Roth conversion transfers money from a traditional IRA to a Roth IRA. You generally pay ordinary income tax on the taxable amount converted in the year of conversion. In other words, you treat the converted amount like extra income you pay tax on.
ROTH CONVERSION RULES OF THUMB
Because converting from a traditional IRA to a Roth IRA costs money, another critical factor is how long a Roth has to compound. Tax-free compounding can eventually pay for the conversion cost and make the transaction profitable if the account is held long enough and not withdrawn. In most circumstances, financial fiduciaries expect payback to take no more than 8-12 years to make sense. After that point, tax-free compounding and the lack of a withdrawal time frame favor the converted IRA. That is why advisors seldom recommend that people with federal rates above 22 percent convert traditional IRAs. A 22 percent cost, plus state tax rates, is a significant price to pay for the privilege of tax-free compounding and tax-free withdrawals.
ROTH IRAs AND COMPOUNDING—THE SNOWBALL
The advantage of compounding can (especially tax-free) be illustrated by a famous example. Warren Buffett has noted that compounding relies on two factors: the size of the initial investment and the length of time. He likened compounding to a snowball rolling downhill, picking up wet snow as it goes and getting larger. He noted that it takes a very long hill (time to compound) to get the best result.
In this case, the conversion payment in effect reduces the snowball’s starting size–but places it on a steeper (tax-exempt) hill.
To extend the analogy, the time to compound is the hill’s length. So, the longer the period of tax-free compounding, the better. And it turns out that having a very long hill is critically important.
HOW LONG IS THE “HILL?”
You don’t know. Does anyone know when they will need money for health costs or extended care? How long will you live? In other words, how long is the hill?
Those are all good questions, but no one knows the answer. Instead, there are only probabilities. Still, the probabilities can help determine whether you are likely to have a “long hill” and whether you should favor Roths as a possible result. Many people’s analysis goes wrong because they don’t know the probabilities. So, here are a few statistics that may help guide decisions.
Remember that most people inherit at age 50-65. A reasonable guess is that they may live to about age 80-82 if they are age 50, according to the Social Security actuarial life tables.
In the case of two partners who inherit at age 60, at least one of the partners is more likely to reach age 90 than not.
So, if your situation is typical, think about an investment period of about 20-30 years as a rule of thumb if you have just inherited a traditional IRA.
That length of time means the 8-12 year Roth conversion payback rule of thumb may be conservative for many people. A conversion that pays back over a longer period of time may be worthwhile. But only if you don’t need the money immediately and are fairly sure about your health.
Add 10 years to that if your kids inherit after you pass. The rules vary; heirs also have 10 years to withdraw. The number of beneficiaries and their ages may affect the timing of annual payments, if any.
While converting a traditional IRA to a Roth is expensive, it may be best for you depending upon your situation and timing.
Or not.
ROTH CONVERSION–WHEN IS IT BEST FOR YOU?
Making the decision is complicated.
Rules of thumb (and snowballs) aside, knowing how to proceed is complicated and requires an individual analysis. I strongly recommend using a fiduciary to do that analysis. I would not proceed without it.
There are a lot of variables that go into the decision:
- Your current situation, including assets, health, etc.
- Your age
- Whether you are collecting Medicare yet
- Your income and tax bracket.
- How you pay for a possible conversion to a Roth
- If you expect your future tax rate to be higher than your current rate, or
- if you want to reduce future RMDs.
BUT, WAIT, AGAIN, WHY ARE WE DISCUSSING AN INHERITED IRA—YOU CAN’T DIRECTLY CONVERT IT INTO A ROTH IF YOU ARE A NONSPOUSE BENEFICIARY
That is true. However, there is a loophole, but it only applies to those who already have both their own traditional IRA’s AND existing Roth accounts.
You can convert your own traditional IRA (not the inherited traditional IRA) to your own Roth. You can use either cash or the inherited proceeds to pay the conversion costs.
MY OWN PLANS
Because of my age and circumstances, I am converting using inherited IRA cash RMD’s to convert my regular IRA to my Roth account for the first 3 years. And then I will take the last 7 years from the inherited IRA, pay the taxes, and save the rest. Much of the savings will go to charity, and the rest will go toward paying off my last debt on a rental property.
A FINAL CONSIDERATION: IF YOUR HEIRS INHERIT, WHAT IS THEIR TAX BRACKET?
I can designate who gets my IRA and brokerage accounts.
I can give the heir in the highest tax bracket the Roth, and they won’t pay tax when I pass away.
Conversely, the heir with the lowest marginal tax rate will inherit the regular IRA. They also won’t pay much tax on the IRA when they inherit it.
The point: The tax situation of your heirs may drive the decision as to whether to convert a traditional IRA to a Roth.
DISCLOSURE
Disclaimer: Consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
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