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Expert Insights for Smart Financial Planning

How a Roth Conversion Can Save You and Your Heirs Thousands

With a Roth, you can avoid RMDs and let more of your money grow tax-free.


If you have an individual retirement account (IRA), you probably already know about required minimum distributions (RMDs). For traditional IRAs, including Simplified Employee Pension (SEP) or a Savings Incentive Match Plan for Employees (SIMPLE), you must take your first RMD in the year you turn 70½ or by April 1st of the following year from when you reach 70½.

See Also: Why You Need a Roth IRA

Converting your traditional IRA to a Roth IRA can help you avoid RMDs and significantly benefit your children and grandchildren.

The conversion is treated as a taxable distribution, meaning you'll owe income taxes on the amount converted in the year you convert. (On the bright side, the rate might be lower if you're already retired.) Still, Roth IRAs are great because the money in the account can grow tax-deferred and any future withdrawals are tax-free to you and your heirs.

To exemplify the benefits of a Roth IRA conversion, consider this scenario: Imagine two fathers at the age of 65, both in a 28% tax bracket. Both fathers have $100,000 in each of their IRAs and $28,000 in a separate taxable account. The first father uses the balance of the taxable account to convert his IRA to a Roth IRA. The other does not convert and keeps his funds in his SIMPLE account.


Over time, the first father's Roth IRA account grows tax-free, and he does not take any RMDs. The father with the SIMPLE begins taking out his RMDs at age 70.

When both fathers die at age 90, both accounts are 25 years old, and the children must begin taking their RMDs. The child who inherited the Roth account has about $685,000, if the annual rate of return was 8%. The child with the SIMPLE has nearly $217,000.

What made such a significant difference in account value? The SIMPLE father and child paid taxes on their RMDs. The father with the Roth IRA didn't take any RMDs, and his child was able to take withdrawals tax-free.

Other benefits to converting your traditional IRA to a Roth IRA: doing so can eliminate or lower federal and state taxes, drop your estate tax bracket and allow you to make earnings from depressed market values on stocks.


Talk to Your Beneficiaries

To ensure that your Roth IRA conversion earnings continue with your beneficiaries, prepare them and encourage them to be a part of the planning process now. If you want your heirs to stretch this tax-free shelter over their lifetimes, talk with them now about the rules they must follow after you die.

IRA account beneficiaries are subject to special distribution rules. Their first RMD is due December 31st of the year after the original account holder's death, or by December 31st of the year the deceased would have reached the age of 70½ (whichever option is the latest). If the original account holder died after reaching 70½, the beneficiary must take his or her first RMD before December 31st of the year after the death.

Most laws for account beneficiaries tend to favor spouses, and they have more choices in the event that they inherit an IRA account. They can merge inherited traditional IRAs into their own Roth IRA account, whereas non-spousal beneficiaries cannot.

Non-spousal beneficiaries must set up an "inherited IRA" under the name of the original account holder. Multiple beneficiaries each need their own "inherited IRA" account so that each heir can base their RMDs on their own life expectancies; otherwise, their RMDs will be generated based on the life expectancy of the oldest beneficiary—which may cause a significant amount of the account value to be lost.


Also, before you convert, consider whether your tax bracket is higher than your child's. For instance, if you're in a 28% tax bracket, and your child is in a 10% tax bracket, it may not make sense to convert. However, most retirees are in a 0%, 15% or 25% tax bracket while their children are in a 33% tax bracket—in which case, a conversion would be beneficial.

Finally, if you decide to convert, use non-IRA funds to pay the income tax owed upon conversion to maximize IRA account value for tax-deferred earnings.

As of 2010, there are no longer income limits that prevent you from converting your traditional IRA to a Roth IRA, so now is the time to take advantage of this account and its growth potential.

See Also: How Much Do You Really Know About Roth IRAs?

Carlos Dias Jr. is a wealth manager and founder of Excel Tax & Wealth Group, an advisory firm offering strategic financial planning services.

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