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Only 41% of investors with more than $1 million have a plan for passing on their wealth to future generations, UBS says.
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As retirees consider their legacy, a popular income tax-saving strategy has become more common, experts say.
The strategy, known as a Roth individual retirement account conversion, transfers pretax or nondeductible IRA money to a Roth IRA, which begins future tax-free growth. The trade-off is upfront taxes on the converted balance.
“Roth conversions are now becoming more of a piece of legacy planning for some clients,” said certified financial planner Ashton Lawrence, director at Mariner Wealth Advisors in Greenville, South Carolina.
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Before the Secure Act of 2019, heirs could stretch IRA withdrawals over their lifetime, which helped reduce yearly income and tax liability. However, certain heirs, including most adult children, now have a shorter timeline to empty inherited IRAs.
When retirees pass away, their children will “probably be in their peak earning years” with a relatively high tax bracket, Lawrence said.
That can create a tax problem because adult children generally must empty inherited IRAs over 10 years following the original account owner’s death, he said. The rule applies to accounts inherited on Jan. 1, 2020, or later.
How Roth conversions can benefit heirs
With many IRA heirs facing a 10-year withdrawal window, “Roth conversions look even more attractive today,” said Robert Dietz, national director of tax research at Bernstein Private Wealth Management in Minneapolis.
Generally, adult children still must empty inherited Roth IRAs within 10 years. However, withdrawals are typically income tax-free, as long as the account has been open for at least five years.
Sometimes, the tax burden is lower when parents pay levies on the Roth conversion upfront, rather than their children paying taxes on IRA withdrawals, Lawrence said. But families need “legacy conversations” and tax projections before making that decision.
Of course, the original IRA owner should also weigh the financial consequences of boosted income for Roth conversion years, such as higher Medicare Part B and D premiums.
Planning for higher income tax brackets
With income tax hikes on the horizon, some investors may consider a few partial Roth conversions, according to Dietz.
Without changes from Congress, lower income tax rates will sunset after 2025. Prior to 2018, the individual brackets were 10%, 15%, 25%, 28%, 33%, 35% and 39.6%. However, five of these brackets are lower through 2025, at 10%, 12%, 22%, 24%, 32%, 35% and 37%.
“For a lot of our clients, we’re looking at Roth conversions over a three-year period,” Dietz said.
The plan is to complete partial Roth IRA conversions from 2023 through 2025 and fill up the client’s desired tax bracket each year, depending on projected taxable income, he explained.
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