Editor’s note: Assunta “Susie” McLane is a longtime contributor to Rethinking65. To read more of her articles, click here.
Assunta McLane
The estate-tax exemption is scheduled to sunset in 2025, so now’s the time to consider an often-overlooked tool that can safeguard wealth for the next generation – the Roth IRA.
The current estate-tax exemption allows an individual to gift tax-free $13.61 million and a married couple $27.22 million during their lifetime or at death. That exemption (created under the Tax Cuts and Jobs Act) will expire on Dec. 31, 2025, and revert to approximately $7 million per individual, adjusted for inflation, unless Congress intervenes.
Now is the time to review your client’s estate plans and work with them to ensure they take full advantage of any planning opportunities, including the Roth IRA. Typically associated with retirement planning, the Roth offers benefits that extend far beyond. While estate planning is about passing on assets to heirs, it’s also about maximizing the wealth you leave behind and minimizing taxes. Utilizing Roth IRAs can be a powerful strategy when it comes to estate planning.
Mitigating Future Tax Risks
With the future of tax rates uncertain, estate and tax planning for clients is crucial. When we convert traditional retirement accounts to Roth IRAs, we are essentially locking in today’s tax rates and shielding savings from potential tax increases.
Unlike traditional IRAs, Roth IRAs offer tax-free growth and tax-free withdrawals. With Roth IRAs, you do not receive a tax deduction when you contribute, but there are significant long-term benefits. The Roth IRA continues to grow tax-free and over decades, the investment gains can compound substantially.
Most high earners are not able to make direct contributions to a Roth IRA because their income exceeds the annual limit for Roth contributions. In 2024, those limits are $230,000 to $240,000 for joint filers and $146,000 to $161,000 for single filers. However, taxpayers who earn too much to contribute directly to a Roth IRA might be able to do so with a back-door IRA.
With a back-door Roth, which has no income limitations, one can make an after-tax contribution into a traditional IRA. The contribution would then be converted from the traditional IRA to a Roth IRA. If your client has no existing traditional IRAs and they immediately convert the contribution from the traditional IRA to the Roth IRA the taxes will be minimal or non-existent. If your client does not have an existing traditional IRA or Roth IRA, they would be required open both accounts in order to complete the transactions.
The back-door Roth strategy works best when your client does not have an existing balance in the traditional IRA. This is because the IRS uses a pro rata rule — applying a ratio to determine how much of a distribution or conversion is pre-tax versus after-tax. If the IRS determines that your client’s traditional IRA balances consistent of a mix of pretax and after-tax money, a portion of the conversion converted to a Roth IRA will be subject to taxes when converted.
A Case Study: Partial Roth Conversions
Jane retired at age 65 after a long and successful career. Upon retiring, she rolled her large 401(k) account balance into a traditional IRA. We knew she would have to start taking required minimum distributions at 73. Her RMDs were going to exceed $300,000 per year, which would put her in a higher tax bracket. After running financial projections, we determined it made sense for Jane to do partial Roth conversions between her retirement and her initial RMDs; her taxes would be lower during these interim years.
In coordination with her accountant, we calculated that Jane could convert $100,000 to $150,000 per year to avoid pushing her into a higher tax bracket. Once she reached age 73 and started taking RMDs, her traditional IRA balance would be significantly smaller. This means lower RMDs would be taxed at ordinary-income rates.
Jane would not be required to take RMDs from the Roth IRA, allowing it to grow tax-free. But if she needed to access the funds for her own personal cash needs, she could do so without it being taxed. Jane also earmarked the Roth IRA for her future beneficiaries.
Being proactive and considering the benefits of Roth IRAs can safeguard wealth and provide peace of mind knowing that beneficiaries won’t be left with a hefty tax bill.
Legacy Planning
Because Roth IRAs do not have RMDs during the original owner’s lifetime, this allows them to leave the funds untouched for as long as they wish and the account to continue growing tax-free.
Once the Roth IRA passes on to the beneficiaries, they will be required to take distributions under SECURE Act 2.0, but they will inherit the benefit of tax-free withdrawals. When you do not convert to a Roth IRA, the beneficiaries inherit a traditional IRA, which requires them to take taxable distributions taxed at their income tax rates. Depending on the size of the inherited IRA this could push them into a higher tax bracket and essentially reduce their after-tax inheritance.
The added bonus of a Roth conversion is that it also reduces the size of the owner’s taxable estate. By converting from a traditional to a Roth and paying the taxes today, your client can reduce their estate’s taxable assets. With the sunsetting of the federal estate tax exemption at the end of 2025, helping to minimize your client’s taxable estate could make all the difference in what they could potentially owe in estate taxes.
Strategies like this can create a lasting legacy by providing financial security for your client’s heirs and potentially even setting up those heirs for a comfortable retirement.
Final Thoughts
Having a mix of taxable, tax-deferred, and tax-free assets can provide flexibility in retirement and beyond. This diversification can help manage your client’s tax liability in retirement and provide options for more tax-efficient withdrawals and estate tax transfers. If your client is retired but have not yet started taking RMDs, this is the perfect time to consider Roth conversions.
Roth conversions can be a powerful tool, offering tax-free growth, legacy planning opportunities, tax diversification and protection against future tax risks. With careful planning, individuals can maximize the wealth they leave behind while minimizing the tax burden on their loved ones.
Assunta “Susie” McLane, is a Certified Financial Planner with Summit Place Financial Advisors, LLC. She can be reached at Assunta.Mclane@summitplacefinancial.com.
