August 30, 2023

Mastering Your Legacy

The Roth IRA Conversion Blueprint for Tax-Savvy Parents

You hate paying taxes. I get it. Signing the check. Watching it clear your account. Knowing full well that your hard-earned money will be spent irresponsibly by your government.
A painful experience all-around.

Despite everything your financial advisor has probably told you about deferring tax payments through your 401(k) and IRA, I’ve got news for you as you approach retirement:

It may be time to start proactively paying taxes.

I used to be on team “minimize taxes at all costs.” I changed my tune on this when the SECURE Act went into effect on January 1, 2020, requiring inherited IRAs to be withdrawn over a 10-year period.

This IRS rule change presents a potential estate planning disaster for children who stand to inherit large sums of money through tax-deferred accounts like a traditional IRA or a 401(k).

I once brought on a new client with $3.8 million in IRA assets. If he unexpectedly passed away, his children could be looking at the following negative tax consequences resulting from large inherited IRA distributions:

  • Higher federal and state tax brackets on earned income
  • Phase-outs of various tax deductions and credits
  • Limitations on retirement account contributions
  • Net investment income tax of 2.8%
  • Capital gains tax increase to 20%
  • Alternative Minimum Tax (AMT)
  • Medicare surtax of 0.9%

Talk about painful… especially when all-of-the-above issues can be avoided with a little planning!

To help my client tackle this issue head-on, I introduced him to a crafty strategy that I’ve been using with clients for years.

A Roth conversion allows you to pay some taxes now, but avoid taxes in the future on all dividends, interest, capital gains, and Roth IRA distributions if you play by IRS rules. Some short-term pain; but potential tax benefits over the long run. This might also prevent his children from receiving massive tax bills when they inherit the money.

I created an excel template to model out the tax consequences of different Roth conversion amounts, considering his various sources of income:

  • Earned income
  • Social Security
  • Pension
  • IRA distributions needed to support his retirement lifestyle
  • Required minimum distributions (RMDs)
  • Possible Roth conversion amounts

I used annual rate of return assumptions of 5% for his IRA and 8% for his converted Roth IRA. Different return assumptions would make sense because Roth accounts are usually invested very differently from traditional retirement accounts, but that is a topic for another day. Disclaimer: those return numbers are just illustrative and, of course, are not guaranteed.

The modeled numbers over the next 16 years were staggering:

  • $350,000 total distributions per year (lifestyle withdrawals, RMDs, Roth conversion, and tax withholding)
  • $974,405 in taxable distributions to support his lifestyle over the entire 16-year period
  • $2,544,889 in conversions from traditional IRA to Roth IRA
    • $220,000 per year for the first four years when he wouldn’t need to live off of IRA assets
    • Roughly $138,000 per year on average in years 5-16, when he may need to start using some of the IRA money to support his lifestyle
  • $130,000 per year withheld to cover taxes

The model has the IRA fully converted to a Roth IRA by 2038, with a potential Roth IRA balance of $4,986,386 given 8% compounded returns. That’s almost $5,000,000 that he and his children would NEVER have to pay taxes on again.

We’ve got a meeting scheduled with his CPA next month to finalize and begin executing the plan. Always consult your tax advisor before embarking on this type of strategy!
The next time you’re working to cut down your tax bill, consider embracing a strategic conversion plan. You’re not just trading short-term discomfort for potential long-term gains; you could be shaping a legacy of financial resilience and empowerment for yourself and the generations to come.

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