Estate planning: smart roth conversion trick

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Many financial planning clients have substantial IRAs, yet they have no need to tap the account for retirement income. Generally, they’ll take only required minimum distributions (RMDs) after age 70-1/2, to reduce the tax bill on unneeded income. This approach may result in a sizable traditional IRA being passed down to the next generation, who also must take RMDs.

“Often, our clients’ children are doing very well financially,” says Marjorie Fox, co-founder of FJY Financial, an investment management and planning firm in Reston, Va. “The income from the inherited RMDs would be added to the children’s other income, and might be taxed heavily.”

Today, ordinary income plus various other taxes could boost the effective tax rate on those second-level RMDs well over 40%. Who knows what tax rates might be in effect when current clients eventually pass their IRAs to future generations?


“In some cases,” Fox says, “clients will do partial Roth IRA conversions. The idea is to stay within a current income tax bracket while minimizing other taxes and charges.” Besides state taxes, Medicare surtax, and various deduction phaseouts, Fox points to Medicare Part B premiums as an add-on that particularly annoys affected clients.

Most Medicare enrollees pay $104.90 a month in 2014 for Medicare Part B, which covers doctors’ bills and certain other items. However, seniors with modified adjusted gross income (MAGI) over $85,000 ($170,000 on joint returns) pay anywhere from $146.90 to $335.70 a month for the same coverage. Roth IRA conversions increase MAGI so savvy planning might call for an annual series of partial conversions now in order to limit future taxes as well as “stealth” taxes such as extra Part B premiums.


Each partial Roth IRA conversion will reduce a client’s traditional IRA, taxable RMDs, and the taxable account that can be passed on to beneficiaries. Roth IRA owners never have RMDs so their Roth IRAs can grow, leaving a larger account to heirs. Roth IRA beneficiaries must at least take RMDs but those payouts won’t count as income and won’t trigger surtaxes, higher Part B premiums, or other charges.

“The key,” says Fox, “is to plan for paying income tax now, at a relatively low rate, rather than having the client or the client’s children pay tax in the future at what is expected to be a higher rate.”


One approach is to convert a substantial amount of the traditional IRA one year, then recharacterize (reverse) just enough of the transaction the next year to wind up with the most tax-efficient Roth IRA conversion. Such reversals are permitted until October 15 of the year after the original conversion so clients can prepare their tax returns to get hard numbers on the ultimate conversion.

“This ‘second look’ strategy can be effective,” says Fox, “but some clients discover they don’t like to pay any tax earlier than necessary, which you wind up doing with a Roth IRA conversion. It may be better to start by dipping a toe in the water, with a small Roth IRA conversion, to see how a client will react.”

Seniors receiving RMDs aren't allowed to convert those dollars to a Roth IRA. For example, a 73-year-old who has a $20,000 RMD this year and wishes to execute a $15,000 Roth IRA conversion would have to withdraw (and pay tax on) $35,000 from his traditional IRA while contributing $15,000 to the Roth account. Therefore, it may be best to begin this strategy with clients well before they reach the time for RMDs. According to Fox, some clients start to trim their traditional IRAs in this manner while still in their 40s.

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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