Question Roth Conversions for Clients Charitably Inclined

Considering tax consequences can help clients leave more to charities and their children.

By Scott Stratton
Scott Stratton
Scott Stratton

People are thinking more about Roth conversions in the aftermath of Secure Act 2.0, which has delayed required minimum distributions (RMDs). There is one scenario, however, where your client should never do a Roth conversion: if they want to bequeath a traditional IRA to a charity.

Charities, unlike heirs, will not have to pay any income taxes on a traditional IRA. A lot of people get this wrong, potentially costing their heirs hundreds of thousands of dollars in unnecessary taxes.

Avoid this mistake

Consider, for example, an elderly parent who has a $1 million IRA, a $500,000 house and $500,000 in stocks in a taxable brokerage account. They want to leave half of their estate to their daughter and half to a charity — perhaps their church, a university or a museum.

The parent decides to leave their IRA to their daughter to avoid probate (which is true). They also plan for their estate to sell their house and stocks to give the proceeds to the charity. Bad idea! The daughter may end up paying 40% in federal and state income taxes on the $1 million IRA and might only net $600,000 after tax.

A better plan

Let’s reverse the beneficiaries now: The parent leaves their $1 million IRA to charity. The charity pays no taxes and gets the full $1 million. The daughter receives the house and stocks. She gets a step-up in basis upon the parent’s death and can immediately sell the house and stocks without owing any taxes. She nets $1 million. Simply switching the IRA to the charity means the heir avoided $400,000 in income taxes

Basically, it’s needless for investors to do a Roth conversion on a traditional IRA that they plan to leave to a charity, and paying taxes on the conversion would be a waste of money.

Instead, encourage your client to make their charitable bequest from their traditional IRA. It’s the most tax-efficient method. And if your client changes their mind about donating to the charity, it is free and easy to change their IRA beneficiary. In contrast, changing a charity in a will may require drafting a whole new will, which could be costly and time consuming.

Another option

There is another opportunity for clients who are charitably inclined. Required minimum distributions (RMDs) in 2023 must start when a person is 73, and in 2033, when a person is 75. But individuals can still make qualified charitable distributions (QCDs) from their IRA starting at age 70½. QCDs are non-taxable when made directly from an IRA to a charity. Individuals may donate up to $100,000 a year to QDCs, and Secure 2.0 has indexed this amount to inflation.

Additional Reading: Delaying RMDs: Help or Hindrance? 

In addition, it’s unnecessary to itemize deductions when making a qualified charitable distribution. It is simply a tax-free distribution from an IRA. And once someone commences taking RMDs, a QCD will count toward their annual RMD but will not be considered taxable income.

Conversations can help

 People are living and working longer, and their largest asset is often their IRA. But most clients aren’t thinking about the taxes that must be paid after they pass away. Roth conversions are a great idea for many, but advisors should have thorough conversations to understand their client’s charitable goals and estate planning needs. Think, too, about what taxes will be paid by their heirs and how you can help manage those taxes in advance.

Scott Stratton, CFP, CFA is the founder of Good Life Wealth Management, a Registered Investment Advisor in Hot Springs, Arkansas. You can reach Scott at scott@goodlifewealth.com.

 

 

Latest news

Black Swan Fears Drive Caution, Plus 60/40 Three-Decade Performance

VIX sees record trading as looming economic and geopolitical risks keep investors cautious about a potential return of volatility.

Carson Group: Still Too Few Women in Wealth Management

Its latest report confirms the industry has made little progress in gender diversity despite a lot of talk.

Supreme Court Seems Wary of SEC’s In-House Tribunals Without Juries

The Supreme Court discussed a case involving a hedge fund manager in which the SEC brought a civil enforcement proceeding that charged he mislead investors.

Annuity Sales Continue March Upward

Annuity sales are set to have another record-breaking year, based on results in the third quarter.

Humana, Cigna in Talks to Merge

A deal would give Cigna a much greater foothold in the fast-growing market for managing federal Medicare plans for older Americans.

Aretha Franklin’s Sons Awarded Late Singer’s Real Estate

They now own the late singer's real estate after a judge ruled that a handwritten will found hidden in her sofa was the correct document.