Grandchildren as IRA beneficiaries - convert to Roth?

[Guest MountainMan]

My IRA has a very high value (well over $4 million). My grandchildren are designated beneficiaries. I am retired and can control my annual income, other than SS. I have not reached age 70 1/2 yet. Would it make sense to convert some or all of the IRA over to a Roth?

[John G]

There is no off the cuff response to your question. I can think of some scenarios where conversion might make sense and a lot of scenarios where it would not. {This comes from someone who did big conversions in 1998, and while it worked out for me, it was not the slam dunk that I had expected. My accountant raised a number of concerns that helped me frame my decision.}

The details are very important: your tax rate now, ages of grandchildren, their tax rates, your state income tax (better to convert in a no income tax state), you income needs from the IRA, your expected lifetime, etc. You need a model that incorporates the key parameters so you can evaluate a range of scenarios. Your proposal can not be evaluated by back of the envelope number crunching. You need to run this by your tax advisor, in part because there are so many details that are important, but to also give you a contrary view of the value of your options.

I would not do massive income manipulation to qualify for a conversion. But, if with minor controls over timing (shifting 4th qtr to the new year) you could meet the income qualifications, you might want to a partial conversion. Note, that as the converted amount moves up, you would eventually bump up in tax bracket. A partial conversion often provides significant benefits and would be less costly. Note, there have been proposals to eliminate or modify the income threshold for conversions in future years.

Here are two more things your should consider: (1) if your grand children are employed and/or have earned income - help fund their own Roths, and (2) consider the generation skipping tax provisions realted to estates where you can leave up to 1 million to each grandchild and not trigger estate taxes (of course estate tax thesholds are moving around). I don't recall if generation skipping provisions apply to IRAs.

Again, there is no simple answer to your question. You need someone familiiar with your facts to help you walk through some scenarios.

[Guest allancoleman]

Hello MountainMan ,

John G's answer is correct as far as it goes . I'm a big believer in Roth conversions and have done many to the tune of $772k in taxfree Roths thus far ever since they were first allowed . To me , the key to figuring out if you should do Roth conversions is to figure out if you're going to be in a higher tax bracket when you retire as i figured i would be .

Another calculation you can run for yourself is to calculate the deferred amount you think you'll have at age 70 and divide that number by 27.4 . If you are not happy taking that amount for your first required minimum distribution , then consider doing some Roth conversions . Your 4 million dollar number would require you to take $145,985.40 as your first RMD . Your next divisor for the next year would be 26.5 and so on . Keep in mind that as your IRA balance grows , so may your RMD amount you must take out every year and the income taxes you'll have to pay . For myself , i calculated that if i didn't start my Roth conversion program years ago that at age 70 i would have been in the highest tax bracket forever after that date . And i'd rather convert in the 25% marginal tax bracket now ( 14% to 16% ' effective ' tax rate ) than to pay in the 35% plus tax bracket later . Also keep in mind that our present tax brackets will probably increase in the future making these Roth conversions more expensive later . I can easily see a return of the 39 1/2 % tax bracket for us " rich " folks .

All of my Roth conversions were done at the " effective " tax rate of 14% to 22% , with most done in the 14% to 16% effective tax rate . Keep in mind that the effective tax rate is on every dollar earned . So most of the taxes for my Roth conversions were 14 to 16 cents for every dollar i socked away taxfree FOREVER . I usually pick the " marginal " tax bracket of 25% to work up the size of my Roth conversion . The marginal tax rate is the one on your last dollar earned .

For more research on your Roth questions , you can go to : ( http://www.rothira.com ) . This message board is actually part of this web site and it's how i found my way here . I check here often and appreciate the work the regular contributors do here . Keep up the good work .

[John G]

AC: good additional material on factoring in the RMDs in the post 70.5 period.

I think you are suggesting that the future tax rate of this tax payer is relevant. I am not sure that is correct. I would be more interested in how many grandchildren might be involved, their likely ages when the Roth would pass to them and their income tax rates. (working this out does get complicated and involves a lot of predictions about future events so the likely accuracy of a single scenario is pretty low)

I question how you can convert much of this IRA at low tax rates. I think this persons issues are significantly more complicated than yours due to the size of the IRA.

All that said - lets look at a simple conversion scenario.

First, let's assume that this tax payer is not taking anything out of the IRA (missing fact from the original post) and that via a mix of stocks, bonds and funds that the IRA performance will be around 8%. That means that the without withdrawals, the IRA will increase by about $320,000 in the coming year.

We don't know what the baseline income would be "if controlled", but it sure sounds like this tax payer would need to manipulate his income to stay under 100K to qualify for a Roth conversion. Someone with 4M in IRA assets probably has a significant baseline of taxable interest, dividends and SSN (only SS is mentioned in the post). No mention of a pension. We can rule out zero income. I am guessing closer to 100k is more likely.

If the original author wanted to convert "just the gain" on the account and you had a controlled base income of 100k, you would have taxable income in the year of the conversion based upon $420,000.... for state and federal income taxes. As one of our TV chefs would say.... BAM. The marginal federal tax rate for income over $168,275 in 2006 is 35%.... and that does not include the impact of Sched A and personal exemption phase outs.

I can't difinitively answer the question, but I just don't see how you can convert much of this IRA at low tax rates.

Some clarifying questions for the original author:

1. Are you taking anything out of the 4M IRA now?

2. In coming years, what would be the "controlled" income if you wanted to convert?

3. Based upon the practical limitations of controlling your income, how many years might you be able to keep income under 100k? (if you wanted to do a multi-step conversion)

4. What is a reasonable expected return on your IRA investments... or what is the percent mix for stocks, bonds and cash/moneymarket?

5. Are you married filing joint returns?

6. How many grandchildren are beneficiaries and what is the range of their ages?

7. What is your age?

8. Does your health or family history give you a sense for how long you might live?

9. Do you expect to take voluntary distributions out of this IRA during your expected lifetime?

10. Would you take the minimum amount out after age 70.5?

I want to return to the point I made in my first post. Roth conversion planning is complicated. You need to consider a number of scenarios and many offsetting factors. Before I would take any action, I involve my tax advisor and perhaps estate planning lawyer in a series of discussions. Don't shy away from spending the money for your "consultants" - they will give you contrary views of the future, try to quantify the benefits, suggest how rules changes might benefit your plans, and generally keep "Murphy" far away.

[Guest allancoleman]

You are right , John , that future tax rates aren't relevant to this problem of how to convert such a large deferred amount to a taxfree Roth in a lower tax bracket . But for those other readers younger and able to take advantage of doing a Roth conversion in a lower tax bracket will benefit . If I did not start these Roth conversions years ago when they were first allowed , I would have an additional $772k to factor into my RMDs later at age 70 . And actually probably double that $772k amount as there is probably enough time to pull another double on that amount if it were invested wisely before I come under the RMD regulation as I am only 62 now . MountainMan has " painted " himself into a corner ( unknowingly I'm sure ) by waiting to do Roth conversions until his income is at a point where it's much more difficult to figure a way to convert in a lower tax bracket . Others younger would be wise to consider RMD earlier in their retirement planning to possibily do Roth conversions is a lower tax bracket earlier . For myself , every year that goes by without doing a Roth conversion is a calendar tax year lost in my Roth conversion strategy to convert as much as I can in my deferred accounts before I come under RMD regulations later .

I was fortunate to have retired early and used the last few years to do more Roth conversions in a lower income tax bracket and use real estate sales as " outside dollars " to fund the tax bill and also pay for living expenses while not taking distributions from my deferred accounts ( 401k , IRA ) . For those unaware , " outside dollars " is a term to explain that most advisors don't suggest that one uses dollars inside a deferred account to pay for Roth conversiions and only use dollars " outside " the deferred account to pay the taxes on that conversion . Another term is " personal " money to pay the tax bill on a conversion and once again not money inside a deferred account .

Roth conversions aren't for everyone . And generally only for those who figure they will be in a higher tax bracket in retirement with outside dollars to pay for the taxes of the conversion . But they have worked well for me . Just another point of view . Sure glad I started them years ago . And I intend to get a few more under my belt before I'm 70 and the task is much more difficult when I have to do RMD .

The hundred thousand dollar limitation you mention comes off in 2010 for those with higher incomes , but then we come back under the problem of how to convert and pay taxes in a lower bracket for this fellow with over four million that could very easily be much more later by the time he is age 70 . I guess this is where it's nice to have a problem of too much money .

[John G]

2010 is 3+ years away or two Congressional elections and one Presidential election. I would not base long term plans the rules will not change one or more times by then.

[Guest allancoleman]

You are absolutely correct , John , about long term planning regarding Roth rule changes . I have even heard that Hillary has stated in past speeches of instituting a special tax of the now taxfree Roth withdrawals because they favor the rich . Talk about throwing a monkey wrench into my long term Roth conversion strategy .

I doult whether the Congress would fully support such legislation , but I certainly feel our future income tax rate schedules will change in the future . And I don't see our present schedule staying the same for much longer . Another excellent reason to get another Roth conversion done in our lower tax brackets available now at this time . For those considering such a move , keep in mind that the deadline for Roth conversions is December 31st and NOT April 15th as per Roth contributions . So those wanting to do a Roth conversion for IRS calendar tax year 2006 , only have a few months left to get'her done .

[John G]

One of the goals of this message board is getting the facts straight. Other goals are to avoid touting specific vendors and to sidestep off topic issues like politics/religion.

The following: "I have even heard that Hillary has stated in past speeches of instituting a special tax of the now taxfree Roth withdrawals" strikes me as inuendo.

I was curious enough about your comment to spend some time Googling all things Hillary related to tax policy. I visited her website, the DLC, Bloomburg News, "On the Issues", CNN transcripts, NY Times interviews, and various reputable sources. My findings: tax policy is not a driving issue for Senator Clinton, and I found not a single reference to Roths or IRAs. In about 90 minutes, I found no comments about a "special tax" on Roth withdrawals.

"I have even heard" is insufficient basis for posting material. We have enough trouble keeping track of legislation, private letter rulings and tax court rulings.

My accountant likes to remind me that there is a considerable body of court rulings on "basis" that would favor a continuation of the Roth tax status. The number of Roth account holders are in the multiple millions, a there would be a major rebellion against Congress if they reneged. Sort of a safety in numbers concept. I conclude that a direct assault on Roths is unlikely. If changes were proposed, I believe existing accounts would be grandfathered.

[Guest allancoleman]

When I read on another message board , the reference / post to this speech that Hillary was supposed to have made about a special 2% withdrawal tax on Roth IRAs , there wasn't a good link to it either . I have heard the question asked many times on investment talk shows about how secure the taxfree Roth might be from future taxes . And I agree with you that with the number of people who have opened them , I , too , doult such legislation would ever pass Congress . But , I can certainly see an increase to our present very low tax rates to pay for some of our increased costs for government . And IF that happens , I'll be very glad I've made my past Roth conversions at these low rates that exist now .

Sorry for crossing the line on politics in my post mentioning Hillary . And with our election results last nite , it won't be long before us investors will see the facts regarding our future legislation regarding taxes . It'll be interesting to watch how it unfolds in the future as I have no particular issue with any candidate . My sole focus is making money . . And trying to figure out the best strategy to do that and stay within the IRS tax code .

And , for me , a Roth conversion strategy solved my excessive RMD that I was facing in the future .

[Guest mjb]

obvious response: when Congress curtails a tax benefit they do so only prospectively and do not eliminate the expection of the tax benefits that have accrued prior to the change, e.g., when Congress eliminated universal IRAs in 1986 the change was made effective prospectively for 1987 and amounts contributed in prior years by ineligible employees remained deferred. Also in 2007 Charles Rangel will be chairman of House ways and means Committee where tax legislation orignates, not Hillary. Finally, all tax legislation passed by Congress can be vetoed by the Pres which requires a 2/3 override by both houses of congress to become law. Pres. Clinton vetoed two predesssors to EGTRRA which Pres Bush signed in 2001. However, legislation which is subject to sunset will not be extended (e.g., estate tax reversion to 2001 law in 2011, 15% capital gains rate). Also a withdrawal tax on Roth IRAs can be repealed by future congress since it will not apply on amounts that are held in a Roth IRA.

[Guest allancoleman]

Although I haven't found the reference yet , John G , to making Roths taxable , I did recently read a article on another board I frequent that mentions a article from Barrons about the possibility of making Roths taxable in the future and how it might happen :

http://investment.suite101.com/discussion_print.cfm/66/45844

However , I still agree with most on this board that Roths aren't in any danger at this time of being taxable .

Hope my edit makes my post more acceptable , John G .

[John G]

This thread has gone far afield of the original question.

Mountainman, did you get your original question answered? It is helpful to hear back from the original author.

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PS from one of the moderators: I suggest that political leaders be addressed as position + last name. Referring to one person by the first name and another by their full title is inappropriate and less confusing. We want this message board to be factual and void political slants.