Consider a Roth conversion’s potential to increase the after-tax wealth transfer of an IRA

FROM VANGUARD GROUP

Consider a Roth conversion’s potential to increase the after-tax wealth transfer of an IRA. From a wealth transfer perspective, Roth IRAs have two main advantages over traditional IRAs. First, they do not require account owners to take required minimum distributions (RMDs) during their lifetime. The amounts that would normally be paid out in RMDs and subject to income tax can continue to grow in the Roth IRA tax-free. This will likely result in a greater account balance when the IRA is ultimately transferred to beneficiaries. Second, qualified Roth distributions are tax-free: No income tax is due when withdrawals are taken. These features can mean substantially greater ending wealth for beneficiaries.

 How investors pay the taxes due at conversion can also have a significant impact. Roth conversions may be either tax-exclusive or tax-inclusive. If investors pay the taxes due with assets outside of the IRA, the conversion is tax-exclusive. This is often the better strategy as it transfers the entire pre-tax IRA balance to the Roth account, essentially increasing its after-tax value. On the other hand, in a tax-inclusive conversion, the income tax is paid from the traditional IRA and the beginning value of the Roth is reduced accordingly.

Other estate-planning advantages:

 In addition to potentially passing greater wealth to beneficiaries, a Roth conversion may also provide two important estate-planning advantages:

 • Elimination of double taxation. If an estate is large enough to incur estate taxes, the beneficiaries must pay them on all assets beyond the exemption amount, including tax-deferred assets such as traditional IRAs, 401(k)s, annuities, and other retirement plans. They must also pay income tax on any withdrawals from these accounts, resulting in 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.

 • Reduction of the estate through income tax on the conversion. Upon conversion, the estate is 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.

Evaluate current and future income tax rates for investors and their beneficiaries. The potential benefits of a Roth conversion hinge greatly on tax expectations—the current marginal income tax rate versus the rate when withdrawals from the traditional tax deferred retirement account will be made. A common rule of thumb is that if an investor anticipates similar or higher tax rates in the future, then a Roth conversion will likely be advantageous. If the marginal rate will most likely decline in the future, then maintaining the traditional tax-deferred account may be a sound choice. The decision becomes more complex when planning across generations, but understanding investors’ goals for their retirement accounts can help.

 • Individuals intending to make significant withdrawals from the account for retirement spending should weigh their current marginal income tax rate relative to their expected rate in retirement, factoring in variables such as RMDs and Social Security claiming decisions.

 • On the other hand, investors intending to transfer the account to their beneficiaries should consider the beneficiaries’ future marginal income tax rate. If the beneficiaries will likely be in a similar or higher bracket, converting may be the better option because the conversion taxes will be paid at the investor’s tax rate, and the appreciation of the Roth assets will be sheltered from future income taxation.

Capitalize on annual tax planning opportunities

 • Offset conversion income tax when making charitable contributions. Individuals who are charitably inclined can consider planning annual gifting around Roth conversions. Charitable contributions may typically be deducted up to 50% of adjusted gross income.5 Because a Roth conversion increases adjusted gross income, investors can potentially make larger deductible charitable contributions in the year(s) they convert. This can further their charitable giving strategy and reduce the tax impact of their Roth conversions at the same time

. • Maximize full use of low marginal tax brackets. Some individuals may find that their income is lower in the earlier years of retirement, before RMDs and Social Security benefits start. This may be an optimal time to convert. They can take full advantage of their lower marginal income tax rates during these years by doing a series of partial conversions to “fill up their tax bracket.” Similarly, years in which investors have large tax deductions that place them in a lower tax bracket than normal can also offer excellent conversion opportunities.

• Consider converting if you are paying AMT. Individuals subject to Alternative Minimum Tax (AMT) may be able to reduce the taxes they pay on a conversion. Their AMT rate8 will likely be lower than the marginal income tax rate they would pay otherwise. Depending on circumstances, the conversion amount could be taxed at the lower AMT rate as opposed to the higher rate. Working closely with a tax planner can help investors strike the right balance between converting as much as possible and still remaining within the AMT envelope.