Roth IRA Conversion Can Help Maximize Wealth Transfers

Roth IRA conversions may offer estate-planning advantages, according to a new paper by Vanguard.

Converting pre-tax assets, such as those in a traditional individual retirement account (IRA) or a 401(k) plan, into a Roth IRA can offer advantages for clients in a variety of financial circumstances. 

According to a new Vanguard analysis, Roth conversions can help individuals avoid required minimum distributions (RMDs), for example. Depending on the individual client needs, there are a few ways to achieve this. 

First, the firm says some investors can benefit from converting pre-tax assets into a Roth IRA through a tax-exclusive option. This means that the investor pays taxes due on conversion with assets outside the IRA or 401(k). “This is often the preferred strategy as it transfers the entire pre-tax IRA balance to the Roth account, essentially increasing its after-tax value,” Vanguard notes.

Obviously, paying these taxes with assets inside the account through a tax-inclusive method leads to a smaller opening balance and potential for growth, but often this may be the only choice. 

Vanguard explains how the tax-exclusive conversion can support beneficiaries inheriting these assets using a hypothetical 65-year-old investor with a taxable account balance of $28,000, a traditional IRA balance of $100,000, and a 40-year-old non-spouse beneficiary. Both are in the 28% tax bracket and the following calculations assume no estate taxes are due at the account owner’s death and the income tax rate for both parties remains constant over time.

In the first scenario, the account owner maintains the $100,000 traditional IRA and the $28,000 taxable account, reinvesting all income and dividends. She begins taking RMDs at age 70.5 and reinvests the after-tax proceeds in her taxable account. Upon inheriting the IRA, her beneficiary begins taking RMDs according to his life expectancy and reinvests them, net of taxes, into the taxable account.

In the next scenario, the account owner converts the entire traditional IRA to a Roth IRA and pays the conversion taxes from the IRA while maintaining the taxable account (a tax-inclusive Roth conversion), leaving her with a $72,000 Roth IRA and a $28,000 taxable account. She does not take any withdrawals from the Roth IRA during her lifetime. Upon inheriting the Roth IRA, her beneficiary takes RMDs (income-tax free) based on his life expectancy and invests them in the taxable account.

The next scenario is identical to the last one, except the account owner pays the conversion taxes using the money in her taxable account (a tax-exclusive Roth conversion with the full balance converted), leaving her with $100,000 in her Roth IRA and no balance in her taxable account.

Vanguard’s calculations determine the account balances to be as follows after 30 years from conversion: $536,850 for the first scenario; $572,903 for the next scenario; and $602,461 for the last one.

NEXT: Estate-planning advantages

Vanguard also offers insight into how conversion into a Roth IRA can offer several estate-planning advantages. If an estate is large enough to incur estate taxes, the beneficiaries are required to pay them on all assets that don’t exceed the exemption point. This includes tax-deferred assets, traditional IRAs, 401(k)s and other retirement plans. Furthermore, they must pay income tax on any withdrawals form these accounts leading to double taxation.

“Thus, it is generally more advantageous to pass assets that do not have an embedded income tax liability, such as a Roth IRA or taxable assets,” Vanguard argues.

The firm also says “the estate can be reduced by the conversion taxes paid and any future appreciation of those dollars. Even if the reduction isn’t large (and many individuals are not subject to estate tax at all), using this method does not reduce the owner’s gift/estate tax exemption. However, because the investor’s estate will include the Roth IRA (and its potential growth), a Roth conversion may increase a taxable estate over time, possibly beyond the savings achieved by converting. For those with sizable estates, it is especially important to consider all of the implications before making a decision.”

The advantages of investing into a Roth IRA largely depend on tax expectations, which can be extremely difficult to determine. Generally speaking, a Roth IRA is potentially most useful for investors who predict their income tax obligations would increase as they approach retirement, because taxes avoided upon distribution would be larger than those levied while making contributions to the account. The matter can become more complex when planning across generations, highlighting the importance of analyzing an individual’s particular goals for a retirement account,

For further guidance, access “Roths Beyond Retirement: Maximizing Wealth Transfers” by Vanguard.