As we all open a fresh calendar, many folks are looking at their resolutions and trying to lay out their plans for this year. Plans for travel, philanthropy and home renovation projects are high on the list for many of the families we work with. Also, people tend to lay out their financial plans for the new year as they think through taxes for last year. Many are finding that the markets are still in tough shape and that there are new rules relating to the required minimum distribution. In this article, we will look at the rule changes and discuss the pros and cons of a Roth conversion in this environment. My hope is that you walk away with a firm grasp of the rules and how to leverage them to your family’s best advantage.
For decades the rules for aging and distribution were fixed; Reach the age of 70½ and then consult Internal Revenue Service (IRS) publication 590 for your advisor. Take your required total from your accumulated qualified plans and move along. Many firms would even calculate their share of your distribution for you, very straightforward. During the earlier part of my career, we suggested simply automating the payments and maybe withholding a little tax along the way. When someone passed away and left you qualified money (pretax IRA, various workplace saving plans like 401k, and 403b alongside others) you did the same thing. Start with your situation and relation to the decedent, check the tables in IRS publication 590, and distribute your totals. As with many things, the good old days of simple, clear rules that applied nearly uniformly have passed. Now we have new rules that complicate life a little and require more thought.
With the passing of the Secure Act 2.0 folks are now starting to take their distributions later. Previously, the beginning age was 70 or by April the year following. An increase in age to 72 and now, here we are at 73. If that isn’t enough, we will see it bump again in 2033 to begin at age 75. We do not really think these changes are good or bad. They are just a fact of life on a go-forward basis. For many years, late-life Roth conversions seemed to be a rarity. So, given the rules, should we look at Roth conversions differently?
After the original depositor passes away, the inheritance distribution rules changed radically. As mentioned above we used to call these inherited IRAs “stretch IRAs”. Generally, a non-spouse beneficiary would just “stretch” the payments from the inherited qualified accounts over many years based on the tables in IRS publication 590. Now, the law requires that you examine the year of passing, the age of the decedent, the relation of the decedent, and whether the inheritor is a spouse or not. Instead of many years of stretched required payments, now we have a 10-year rule that seems to be in a state of transition. At its simplest, you could inherit an IRA and take payments as needed. The only requirement was having to drain the accounts completely by the tenth year of inheritance. Now, there is possibly going to be an amortization schedule and more rules. Again, this is a matter of compliance and the complexity of that compliance. This isn’t a matter of being a good or bad change. The job of the IRS Service is to create internal revenues. We call them taxes. So, with every regime, comes a new way of thinking about how to levy and collect the revenue required to keep America running.
WHAT IS A ROTH IRA CONVERSION?
Considering all the above, what does that have to do with Roth IRA conversion? First, let us define Roth IRA conversion. In effect, a Roth conversion takes money that has not been taxed yet (qualified IRAs in this example) and moves it into an account that will never be taxed (the Roth IRA). What a novel concept! The issue with Roth conversion is that the IRS will want taxes on the converting amounts. This means you should have a good reason to effectively “pre-pay” your taxes. Why would a person want to prepay taxes this way? The overall goal is to live long enough and have your assets grow enough to cover the tax cost of that conversion. If you pay the taxes now, and never again, you avoid the risks of rising taxes and bequeath a tax-free asset to heirs.
We believe there are three keys to timing the Roth conversion:
1. Having an Abnormally Low-Income Year - In a lower income year, your highest marginal tax bracket could be lower and so you might Roth convert in a lower tax rate. As your income recovers, you may have extra money to help offset the tax cost of the conversion.
2. The Assets You Want to Convert Have Fallen in Value - You don’t have to sell your securities to convert them. Therefore, if they have fallen in value, you pay the tax on the fair market value FMV) on the day of conversion. The hope here is that they reflate quickly after the conversion and help you to recover the cost of the taxes.
3. You Have Confidence That Tax Rates Will Go Up - By converting to a lower tax environment, you are hopefully saving future tax costs, and giving your assets longer to reflate.
THE CURRENT ENVIRONMENT OF ROTH CONVERSIONS
It seems that two of these may be true- The value of many assets is lower, and taxes will change after the tax year 2025 without intervention. The American stock markets began 2022 in a far better place than we still are today. Notionally speaking, if an asset is worth 80% of what it was 2 years ago, the Roth conversion may be less expensive. Especially if you have had a lower income year and may possibly be in a lower tax bracket. From a federal tax perspective, the Tax Cuts and Jobs Act will sunset in 2025. The Build America Back Better legislation from 2021 didn’t come to pass, though it had several elements that could have altered taxes on retirees with qualified accounts. The point here is that historically speaking, taxes on the owners of wealth rarely fall. So, it is possible, that tax-wise, we are in a sweet spot for conversion. I will pause here and say that I am a CFP™ (Certified Financial Planner ™) and an AEP® (Accredited Estate Planner®), but I am not a CPA (Certified Public Accountant). You should surely consult your tax professional before proceeding with a conversion.
ROTH TAX AND FAMILY’S INHERITANCE
Now we must talk about the changing complexity for heirs inheriting a qualified account. As usual in the Wisdom in Wealth discussions, we talk about the fabric of ‘family’. The Roth conversion discussion for families is rooted in the varying tax rates of the current owner and possible inheritors. What will the impact of forcing 10 years of payments on to this possible inheritor be? Is it preferable for the current owners to Roth convert and give a smaller tax-free inheritance, than a larger more taxable legacy? Giving an example, if parents leave a qualified $900,000 account to their only child, that child will have to pay tax on that amount. The questions are when and how much tax? Even if that inheritance could be broken out evenly, with no growth at all over the current ten-year guideline, that’s an income of $90,000 per year. For a married filer in 2023, that income alone aligns with the very bottom of the 22% marginal tax rate.¹ If that inheritor and their spouse both work and earn the 2021 median of roughly $88,000 income², that extra $90,000 would double their income for 10 years subsequent to your passing. $178,000 fills up most of the 22% bracket in 2023 for marrieds.³ Not counting any deductions or special circumstances, a married income of about $90,000 should be taxed at a little more than $12,000.³ That income mostly fills the 10% and 12% income buckets. That additional $90,000 of inherited IRA income would occur in the 22% tax bucket causing the requisite tax of roughly $33,900. That is nearly triple the tax for double the income.
Here are some questions I hope you ponder:
• How does this study of tax make you feel?
• Do your heirs make more or less than the median?
• Will your legacy be larger or smaller than this example?
• Are the taxes for your heirs higher or lower than your rate?
ROTH CONVERSIONS FOR RETIREES
Before we close, the last consideration for both RMD and Roth conversion is the unintended consequence of more income to retirees. Far too few consider that Medicare, Social Security, and Affordable Care Act-based insurance all revolve around your income. A sudden jolt in income can change the costs of these items. Social security for marrieds becomes 85% taxable above $44,000 of income in 2023.⁴ Medicare premiums adjust through income-related monthly adjustments. ⁴ Income over $97,000 in 2023 can trigger a surcharge for Medicare parts B and D.⁴ Affordable Care Act Subsidies are based largely on multiples of the federal poverty line. The poverty line is dependent on your family size and location but ranges between an annual income of roughly $13,800 and $27,700 for families of four. Prior to 2021 if your income was above 400% of that poverty line you risked losing your entire subsidy. Today the scale is a little more generous. At higher levels, you suffer more reductions. ⁶
To summarize this discussion, the timing of your RMDs may be extended depending on your current age. The markets have been pretty tough since last year. Your family may be successful and earn a solid income, following your example. The concept of Roth conversion is complex, but the timing of lower asset prices and tax changes on the horizon warrant a discussion on Roth conversion. That discussion can be for your sake as well as the sake of your family members. Like all strategies, RMD and Roth IRA conversion has very serious considerations for all parties. If you find yourself a little perplexed with all of this, my advice is simple. Let us help. We have the tools lay all of this out visually. We can help you choose your path. We can work with your tax professionals for the execution of the planning, and address future needs and changes as they arise.