Roth IRA strategies will be much more attractive under the new SECURE Act.
It’s not a surprise to find that there are several advantages to a Roth IRA: they can grow tax-free, they are not subject to Required Minimum Distributions (RMDs), and they can pass tax-free to a spouse or heir. The new SECURE Act adds an important advantage for many heirs. Under SECURE, heirs have the opportunity to grow their inherited Roth IRA’s tax-free for 10 years past the death of the IRA owner. SECURE could also kick off a rash of Roth strategies, such as contributory and back-door Roths, Roth 401(k), ‘Mega-Roth,’ and Roth Conversions. The driving reason is that a confluence of issues could make the post-death tax rate of an IRA holder higher than the contribution tax rate. Debating the merits of differing IRA options has often been predicated on the balance of tax rates between the contribution phase and the disbursement phase. There are four contributing factors:
· The tax cuts of the Tax Cuts and Jobs Act are set to expire after 2025
· The RMD math of taxable IRAs generally make the distribution higher as the IRA holder gets older
· With a married couple, the probability is that one partner will eventually be single and taxed at a higher tax rate with large RMDs, and
· SECURE is set up so that most heirs will have to take their distributions within 10 years, which could accelerate the taxes on the heirs
Here’s a case study: consider a 25-year old heir of her grandmother’s $1 million IRA. The SECURE Act could cost her more than $300,000 in additional taxes over the older ‘stretch’ rule, which SECURE eliminates. For many IRA owners, it will be greatly beneficial to their heirs to build Roth assets, which also have to be distributed over ten years, but still pass to the beneficiaries tax-free.
Enter the Roth Conversion. The Roth conversion is a tool that can be used to create Roth assets. The concept is simple: you convert a taxable IRA (or a nondeductible IRA, for that matter) into a Roth IRA by paying the taxes on the conversion. If you have a $10,000 taxable IRA, you pay the taxes and convert it to a Roth. RMD would then disappear and if certain criteria are met, you can withdraw the money tax-free after a prescribed period (generally 5 years), or better, let it accumulate tax-free until up to 10 years after your death and the death of your spouse. It’s important to note you will be paying taxes on a Roth conversion, and it can be a better idea to pay the taxes on the conversion from other assets. So, if Michael and Tania are both 60 and convert $40,000 from his rollover IRA to a Roth, it might cost them about $8,800 in federal taxes (assuming the 22% bracket, which is currently between about $78,951 and $168,400 of taxable income for a married couple). If they let the Roth stay invested at 6%, by the time the last of the two of them die, say at age 90 (30 years), they would have about $229,700 at the death of the second spouse. Their kids, if they continue to leave the Roth invested over the ten-years, assuming a 6% return, would have about $411,400, tax-free.
The Charity Offset. An interesting strategy is to offset a Roth conversion with a charitable donation. You get a deduction for the charitable contribution which reduces your taxable income. With the newer (temporarily) higher standard deductions, this can be beneficial. Let’s take a couple, over 59 ½, with a large 401(k) plan. Their itemized deductions are $30,000, which include annual charitable contributions of $10,000. They can do an in-service withdrawal from their 401(k) to an IRA and then convert that IRA to a Roth. This creates $100,000 of income. They can offset this with a $100,000 Donor Advised Fund (DAF) contribution. If they use cash for the DAF, they can deduct the entire amount since the donation ($100,000) does not exceed 60% of their income ($150,000 plus $100,000, less $6,000 excess itemized deductions over the standard deduction), which is the limit on charitable contributions (the unused portion can be carried over). They increased their income by $100,000 with the Roth conversion, and offset it with a charitable contribution of $100,000. They now use the Donor Advised Fund to make their contributions for the next ten years or so and take the higher standard deductions until 2026. They also make income on the DAF.
Appreciated Property. If they donated appreciated property, like stock worth $100,000, the limitation is generally 30% of Adjusted gross income (in their case, $75,000). The unused portion can be carried over for up to 5 years. Since the deduction exceeds 30% of their Adjusted Gross Income, they would then take the standard deduction instead of itemizing. The DAF would provide for their charitable purposes.
The result:
· $100,000 DAF, and the possible elimination of Capital Gain if appreciated property is donated to the DAF.
· The $75,000-$100,000 current deduction is offset by the Roth Conversion (possible carryover of unused deduction).
· The $100,000 Roth IRA could have no RMDs, no taxes to kids, and the possibility for a 10-year post-mortem continued tax-free deferral.
Our donors above, presuming they lived 30 years, would accumulate about $574,000 in their Roth (30-year time frame at 6% per year assumed rate of return) by the death of the second party. If they left it to their kids, who left it alone for 10 years, the kids would have a little over a million bucks (10 years at 6% return per year). The donors still made all their charitable contributions and gained $4,000 more in tax deduction by choosing to employ the standard deductions.