For those whose estates are large enough to face estate taxes—that is, greater than $12.92 million ($25.84 million for couples) in 2023—it makes sense to do as much as you can now to lessen the tax hit your estate might face later.
To this end, one common tax-smart strategy is a Roth IRA conversion, in which you move some or all of your money from a tax-deferred retirement account into a Roth IRA. This move requires you to pay income taxes on any pretax funds in the year of the conversion, but doing so has two main benefits for your heirs:
- They won't owe any income tax on withdrawals from the account (assuming the Roth account is at least five years old—if it's less than five years old, only the earnings would be taxed). By comparison, distributions from an inherited traditional IRA are taxable.
- If they don't need the money right away, they can leave it in the Roth account to potentially grow tax-free. Depending on the type of beneficiary they are, the money could continue to grow tax free for five or 10 years—longer if they qualify for a stretch IRA.
Plus, performing a Roth IRA conversion has the advantage of helping to immediately lower the value of your estate by the amount of conversion income taxes paid—ultimately reducing potential estate taxes for your family.
Could a Roth IRA conversion be right for you? Here are three scenarios in which a conversion strategy could help benefit your legacy planning.
1. You're nearing the estate tax threshold
If your estate's value is closing in on or already exceeds the current estate tax exemption, a Roth conversion may make sense. Also keep in mind that the exemption is scheduled to significantly decrease to an estimated $7 million per person in 2026. So even if you're under the threshold now, you might not be for much longer.
Although you'll pay income taxes on any converted assets, the up-front income tax hit will reduce the size of your estate that could be subject to the 40% federal estate tax (if your estate is over the exemption amount). By comparison, the highest income tax bracket is 37% for 2023. While three percentage points doesn't seem like much, the savings could be significant for your high-net-worth beneficiaries.
Take the example of a single father with assets valued at $21 million, including $8 million in a traditional IRA. If he converts his entire IRA to a Roth, at the 37% rate he would owe $2.96 million in income taxes. In turn, his estate would be reduced to $18.04 million—potentially leaving his daughter an additional $1.18 million in estate taxes avoided.
- With a Roth conversion
- Without a Roth conversion
Original estate value>With a Roth conversion$21 million>Without a Roth conversion$21 million>
Amount converted to Roth>With a Roth conversion$8 million>Without a Roth conversionn/a>
Conversion taxes due (37%)>With a Roth conversion$8 million x 37% = $2.96 million>Without a Roth conversionn/a>
Reduced estate>With a Roth conversion$21 million – $2.96 million = $18.04 million>Without a Roth conversionn/a>
Estate tax exemption>With a Roth conversion$12.92 million>Without a Roth conversion$12.92 million>
Taxable estate>With a Roth conversion$18.04 million – $12.92 million =$5.12 million>Without a Roth conversion$21 million – $12.92 million = $8.08 million>
Estate taxes due (40%)1>With a Roth conversion$5.12 million x 40% = $2,048,000>Without a Roth conversion$8.08 million x 40% = $3,232,000>
1Federal estate taxes max out at 40% for taxable amounts greater than $1 million. This hypothetical example is only for illustrative purposes.
And since he already paid income taxes on those assets, any distributions his daughter takes from the Roth account will generally be tax-free—whereas she'd owe income taxes on withdrawals from an inherited traditional IRA.
2. You want to reduce RMDs for your heirs
Even if your assets fall below the lifetime gift and estate tax threshold, if you have retirement funds that you won't need, you may want to consider a Roth IRA conversion to help maximize the tax efficiency of the assets your heirs inherit.
All non-spousal heirs are subject to RMDs on retirement account assets they inherit, which means they must take distributions from the inherited accounts whether they want to or not. If they inherit a tax-deferred retirement account, like a traditional IRA, those RMDs will add to their taxable income. But if they inherit a Roth account, their RMDs will be tax-free, as long as the account was open for at least five years.
Consider a different scenario involving the father and daughter above. Let's say the father is in the 28% tax bracket and lives in a state with no income tax. His daughter is in the 37% income tax bracket and lives in a high-tax state with a rate of 12%. If the father converts the IRA assets to a Roth, he pays the 28% income tax rate. If he doesn't convert the IRA, upon inheritance his daughter will be required to take RMDs in years 1-9 and the remaining assets in year 10—all taxed at a combined federal and state rate of 49%. The difference in overall income taxes paid is significant, making the case to at least consider a Roth conversion.
3. Your business interests align
For business owners who placed a share of their business interests into a traditional IRA account early on and anticipate significant future appreciation, taking the tax hit now through a Roth IRA conversion could add great value to your family's after-tax wealth.
For example, say you founded a startup and placed 250,000 shares of the company stock, which at the time was valued at $0.01, in your traditional IRA. Today, each share is worth $5, but has the potential to climb much further. If each share is worth, say $25 when you pass, your heirs will inherit a traditional IRA worth $6.25 million. Their RMDs could trigger a significant tax bill each year. If you were to convert the traditional IRA to a Roth IRA today, when it's worth $1.25 million (250,000 x $5), you would pay just $462,500 on the conversion—far lower than the total taxes your heirs would owe on the future value of the traditional IRA. And your heirs won't owe any taxes on the appreciation—effectively transferring $5 million ($6.25 million – $1.25 million) free and clear.
Conversions, your way
There's nothing in the rules that says you need to convert all your traditional IRA assets to a Roth in one fell swoop. You can always convert funds at a later date, or even set up a recurring conversion schedule to spread out your income tax liabilities over time. For example, you might be better off waiting if you expect your income-tax rate to fall in future years, or you might convert just enough to keep additional distributions from being taxed at the next highest tax bracket. Keep in mind that when you do a Roth conversion, you increase your income and it can affect other areas of your financial situation, such as itemized deductions and income-related monthly adjusted amount (IRMAA).
Roth IRA conversion calculator to see how it may impact your tax situation. Consider working with your financial consultant or wealth consultant, to help determine whether it makes sense for your particular financial situation and your larger estate-planning and legacy goals. " id="body_disclosure--media_disclosure--141301" >
No matter what your situation is, converting assets to a Roth IRA is a big decision—and an irrevocable one. You can use our Roth IRA conversion calculator to see how it may impact your tax situation. Consider working with your financial consultant or wealth consultant, to help determine whether it makes sense for your particular financial situation and your larger estate-planning and legacy goals.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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This information is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, and/or attorney. The information provided here is for general purposes only and should not be considered an individualized investment strategy, recommendation, or personalized investment advice. Each investor needs to review their strategy in light of their own particular situation before making an investment decision. There are minimum requirements to work with a consultant and the Tax, Trust, and Estate Group. Wealth management refers to products and services available through the operating subsidiaries of The Charles Schwab Corporation, of which there are important differences including, but not limited to, the type of advice and assistance provided, fees charged, and the rights and obligations of the parties. It is important to understand the differences when determining which products and/or services to select.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59 1/2 are subject to an early withdrawal penalty.
Stretch IRAs are designed for investors who will not need the money in the account for their own retirement needs.
Investing involves risk, including loss of principal.1023-3515