ROTH IRA – A Lot To Consider

Image source: Getty Images

ROTH IRA – A Lot To Consider. Roth IRAs are still a big deal. This is still true after the changes included in the Tax Cuts and Jobs Act (TCJA) and all the implications of the COVID-19 crisis.

To learn more about the Tax Cuts and Jobs Act (TCJA) click here. 

COVID-19 Crisis Creates Perfect Storm for Roth IRA Conversions

The financial fallout from the COVID-19 crisis might create a once-in-a-lifetime opportunity to do Roth conversions at an affordable tax cost and thereby gain some insurance against future tax rate increases.

Information on Roth IRAs from the IRS 

Roth IRA Tax Advantages

1.    Tax-Free Treatment for Qualified Withdrawals

Unlike withdrawals from a traditional IRA, qualified Roth IRA withdrawals are federal-income-tax­ free and usually state-income-tax-free too. In general, a qualified Roth withdrawal is one taken after the account owner has met both of the following requirements:

1. Has had at least one Roth IRA open for over five
2. Has reached age 59½, become disabled, or become dead. [See IRC Sec. 408A(d)(2).]

In meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which an individual makes his or her initial contribution to a Roth account. That initial contribution can be a regular annual contribution, or it can be a contribution from converting a traditional IRA into a Roth account. (See Reg. 1.408A-6, Q&A-2.)

Example: Five-Year Rule

You opened up your first Roth IRA by making a regular annual contribution on 4/15/17 for 2016 tax year. The five-year clock started ticking on 1/1/16 (the first day of your 2016 tax year), even though the contribution was not actually made until 4/15/17. You will meet the five-year requirement on 1/1/21. From that date forward, you can take federal-income-tax-free Roth IRA withdrawals-including withdrawals from a new Roth account established with a 2020 conversion of a traditional IRA-as long as you are 59½ or older on the withdrawal date.

2.        Exemption from Dreaded Required Minimum Distribution (RMD) Rules

The original owner of a Roth account need not take any annual required minimum distributions (RMDs) from the account [IRC Sec. 408A(c)(4)]. In contrast, RMDs must be taken from traditional IRAs, starting at age 72, and those RMDs will be at least partially taxable. The taxable amount of an RMD taken from a traditional IRA depends on whether the client has made any nondeductible contributions over the years. If nondeductible contributions have been made, they create tax basis in the IRA, and a percentage of each RMD will be a nontaxable return of basis. The remaining percentage of each RMD will be taxable gross income.

On the other hand, you can leave any and all Roth accounts set up in your name untouched for as long as you live. This important privilege makes the Roth IRA a great vehicle for accumulating wealth you plan to leave to your heirs.

The CARES Act suspended RMDs for 2020.

3.   Tax-Smart Wealth Transfer Vehicle

The two aforementioned tax advantages make the Roth IRA a great vehicle for accumulating wealth that you want to leave to your heirs. After an original Roth account owner departs, and the Roth IRA beneficiary, or beneficiaries, must follow the same RMD rules that apply to inherited traditional IRAs. But those rules are favorable.

• If your surviving spouse is the sole beneficiary of your Roth IRA, he or she can treat inherited the account as his or her own Roth IRA. That means your surviving spouse can leave the account untouched for as long as he or she lives.
• If a non-spouse beneficiary inherits your Roth IRA, he or she can leave it untouched for at least 10 years [IRC 40l(a)(9)(H)]. As long as an inherited Roth account is kept open, it can keep earning tax-free income and gains. The beneficiary can take federal-income-tax-free qualified withdrawals from the inherited Roth account as long as the account has been open for more than five years.

 

Example 2 – Roth IRA as Estate Planning Vehicle

Troy is age 65 when he converts his substantial traditional IRA into a Roth account in 2020. He lives 12 more years and never takes any withdrawals from the account.

Troy’s wife Vanessa is age 70 when Troy dies. Vanessa inherits Troy’s substantial Roth IRA as the sole account beneficiary. According to the current IRS life expectancy table, Vanessa can expect to live another 17 years. She treats the inherited Roth IRA as her own account, which means she need not take any RMDs during her lifetime. Being tax savvy, thanks to your professional advice, Vanessa leaves the Roth IRA untouched.

At age 87, Vanessa passes away and leaves the Roth IRA to daughter Willow, who was designated as the new account beneficiary when Vanessa took over Troy’s account.

Willow is age 50. She must liquidate the inherited Roth IRA within 10 years after Vanessa’s death [IRC Sec. 401(a)(9)(H)]. But Willow is not required to take any withdrawals before the 10-year deadline. Under current law, any withdrawals taken by Willow will be federal-income-tax-free qualified Roth IRA withdrawals. Since Willow is tax-savvy like her parents, she withdraws nothing until she hits the 10-year deadline.

In this example, following the Roth conversion strategy allowed our imaginary family to accumulate federal-income-tax-free income and gains in the Roth account for 39 years: 12 years with Troy, 17 years with Vanessa, and 10 years with Willow.

 

Is This the Perfect Storm for Roth Conversions?

Could be. However, clients must understand that a Roth conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a payout from the traditional account with the money then going into the new Roth account. So, doing a conversion will trigger a bigger federal income tax bill for the conversion year, and maybe a bigger state income tax bill too. Even so, right now might be the best-ever time to convert  a traditional IRA into a Roth IRA . Here are four reasons why.

Relatively Low 2020 Tax Rates Thanks to the TCJA

The individual federal income tax rates for 2020 might be the lowest we will see for the rest of our lives. Thanks to the Tax Cuts and Jobs Act (TCJA), rates for 2018-2025 were reduced. The top rate was reduced from 39.6% in 2017 to 37% for 2018-2025. However, the rates that were in effect before the TCJA are scheduled to come back into play for 2026 and beyond.

Concern:  Rates could get jacked up much sooner than 2026, depending on events, politics, and to help the federal government recover some of the trillions dished out in response to the COVID-19 crisis. Believing that rates will only go back to the 2017 levels in the aftermath of the COVID-19 mess might be overly optimistic.

2020 Tax Rates Might Be Even Lower Due to COVID-19 Fallout

You won’t be alone if your 2020 income takes a hit from the COVID-19 crisis. If that happens, your marginal federal income tax rate for 2020 might be lower than what was expected. Maybe much lower. A lower marginal rate translates into a lower tax bill if you convert a traditional IRA into a Roth account in 2020.

Watch out if we are talking about converting a traditional IRA  with a large balance-say, several hundred thousand dollars or more. The conversion would trigger lots of extra taxable income, and the client could wind up paying federal income tax the top three rates of 32%, 35% and 37% on a big chunk of that extra income. That said, paying 32%, 35% and 37% might soon seem like the “good old days” before too long.

Example 3 – Tax Rate Risk

Converting a traditional IRA with a relatively big balance in 2020 could push you into higher tax brackets. For example, you are single and expect 2020 taxable income to be about $100,000, your marginal federal income tax bracket for 2020 is 24%. Converting a $200,000 traditional IRA into a Roth account in 2020 would cause most of the extra income from converting to be taxed at 32% and 35%.  But if you spread the $200,000 conversion 50/50 over 2020 and 2021, most of the extra income from converting would be taxed at 24% and the remainder at 32%.

This assumes your 2021 taxable income before any extra income from converting remains at about $100,000. Obviously, having  most of the extra income  from converting taxed at 24% and the rest at 32% is better than having most of it  taxed at 32% and 35%.

Note:  This s example also assumes that our current individual federal income tax rate regime stays in place through 2021. Will it? Nobody knows. It depends on events and politics.

Lower IRA Balance after Stock Market Fluctuations = Lower Conversion Tax Bill

In early 2020, U.S. stock market averages reached all-time highs. Then the COVID-19 crisis happened, and the averages dropped significantly. And then rebounded.  As of 12/3/2020, WOW – Please Explain!

Depending on how money in your traditional IRA was invested, your traditional account might have increased in value.  Accordingly, the increase will be treated as ordinary income when it is eventually withdrawn. While the current maximum federal income tax rate for individuals is “only” 37%, what  will it be five years from now? 39.6%? 45%? 50%? 55%? Nobody knows – but betting it will be lower than 37% seems inadvisable.

No RMDs for 2020

The CARES Act suspended RMDs for calendar year 2020. Usually, if you are subject to the RMD rules and you want to convert your traditional IRA(s) to Roth status, you must first withdraw your annual RMD amount from the traditional account(s) before converting. You are taxed on the RMD, and the withdrawal of the RMD reduces the traditional IRA balance(s) that you can convert. But   not for 2020. You can convert the full amount of your full traditional balances, if you wish.

Conclusion on Roth Conversions

Clients who do Roth conversions in 2020 will be taxed at relatively low federal income tax rates on the extra income triggered by their conversions. That said, there will be a 2020 tax hit. However, if you convert in 2020 you will avoid the potential for higher future federal income tax rates  (maybe much higher) on all the post-conversion income and gains that will accumulate in the new Roth account. That’s because Roth withdrawals taken after age 59½ are totally federal-income­ tax-free, as long as the account owner has had at least one Roth account open for more than five years when withdrawals are taken.

If you leave a Roth IRA balance to an heir, the heir can take federal-income-tax-free qualified withdrawals from the inherited account balance, assuming the account has been open for more than five years.

In summary: relatively low federal income tax cost for converting in 2020, plus an opportunity to avoid higher tax rates in future years on income and gains that will accumulate in a Roth account = The perfect storm for Roth conversions.

 

Roth Conversion Details

Partial Conversions are Allowed

Say your client has several traditional IRAs. She can choose to convert some accounts and leave the rest alone. Similarly, she can choose to convert only a proportion of the balances in one or more traditional IRAs and leave the rest of her balances in traditional IRA status.

Client and Spouse can Operate Independently

Say your client is married, and both have traditional IRAs. Client and spouse can consider the Roth conversion opportunity independently for their respective traditional IRAs. What one spouse does (or does not do) has no effect on the other spouse – other than the impact on joint AGI and joint taxable income that results from making a conversion (or not).

Impact of Nondeductible Contributions under Account Aggregation Rule

Say your client has several traditional IRAs and has made nondeductible contributions over the years to one or more of these accounts. He chooses to convert some but not all of his traditional IRA balances to Roth status.

The nondeductible contributions will generally make the deemed distribution from the conversion partially taxable and partially tax-free. The calculation of the taxable and tax-free amounts is based on the aggregate balance of all of the client’s traditional IRAs (including any SEP-IRAs or SIMPLE IRAs) on the conversion date and the aggregate amount of all nondeductible contributions to those accounts. (See IRC Sec. 408(d)(2).) This account aggregation rule means the taxable and tax-free percentages of the deemed distribution from a conversion will be the same, regardless of which traditional IRA is actually converted. (Accounts owned by the client’s spouse have no impact on the client’s account aggregation calculations.)

Example 1

Fred owns 2 traditional IRAs: IRA-1 and IRA-2. Each account is worth $40,000. The entire $40,000 balance in IRA-1 is from deductible contributions and earnings . In contrast, the $40,000 balance in IRA-2 is from $20,000 of nondeductible contributions and $20,000 of deductible contributions and earnings.

Fred converts IRA-2 into a Roth account. The resulting $40,000 deemed distribution would be 25 percent tax-free ($20,000/$80,000 = .25) and 75 percent taxable ($60,000/$80,000 = .75). Therefore, Fred will have a $30,000 taxable distribution ($40,000 x 75% = $30,000) to report on his Form 1040. If he expected the deemed distribution to be 50 percent tax-free (since half of the IRA-2 balance was from nondeductible contributions), he will be disappointed.

Key Point:  Pursuant to the account aggregation rule, converting IRA-1 would also result in a $30,000 taxable distribution.

Variation: In the rare circumstance where the aggregate value of Fred’s traditional IRAs on the conversion date is equal to or less than the aggregate amount of his nondeductible contributions to the accounts, the conversion of one or both accounts would not trigger any taxable income. In such case, there does not appear to be any downside to converting both accounts into Roth IRAs.

How To Accomplish Conversions

There are three basic ways to accomplish a conversion by moving funds from a traditional IRA into a Roth IRA:

1. In-house Conversion. Account holder simply recharacterizes the entire existing traditional IRA into a new Roth account managed by the same IRA trustee or custodian. This action can be taken for some or all of the client’s traditional IRAs. All that is required to achieve a conversion in this manner is filling out a form and submitting it to the trustee or custodian. With such an “in-house” conversion, there is no need to liquidate the converted account’s assets. Any stocks, mutual funds, and so on, are transferred automatically from the old traditional IRA into the new Roth
2. If the client wants to switch his IRA trustee or custodian as part of the conversion process (for example, by converting an existing traditional IRA held at a bank into a new T. Rowe Price Roth IRA), the initial step is to make a direct trustee-to-trustee transfer of the traditional IRA’s assets from the bank to a new T. Rowe Price traditional IRA. This step is tax-free, and it keeps the account’s assets intact. Then the client can make an “in-house” conversion of the T. Rowe Price traditional IRA into a T. Rowe Price Roth IRA. This last step of the process is a taxable event.
3. Another way to achieve a conversion is to withdraw some or all of the funds from 1 or more traditional IRAs and then roll the funds over by contributing them to 1 or more new or existing Roth accounts under the familiar 60-day rollover

All three of the above procedures are referred to as conversions in this chapter.

Recommendation:  Other things being equal, it is prudent to keep Roth conversions simple by:

(1) converting the entire balance of a traditional IRA rather than just a portion, and

(2) setting up a new Roth IRA to receive each significant Roth conversion contribution. Setting up a new Roth account for each conversion contribution makes it much simpler to reverse a conversion that does not work out.

Required Minimum Distributions Cannot be Converted

The Roth conversion privilege is still available after a traditional IRA owner has turned age 70½. However, required minimum distribution (RMD) amounts cannot be converted. (See Reg. 1.408A- 4, Q& A-6 .) Therefore, an older client can only convert the amount left in her traditional IRA(s) after subtracting the RMD amount for the year of the conversion.

Retirement Plan Balances Can Be Converted

Clients can also make direct (trustee-to-trustee) rollovers of distributions from their tax-deferred qualified retirement plan accounts (for example, 401(k) plan accounts, profit-sharing plan accounts, and so forth) into Roth IRAs. In effect, this is just another way to accomplish a Roth conversion. Specifically, the direct retirement account rollover and conversion privilege is allowed for distributions from qualified retirement plans, Section 403(b) tax-sheltered annuity arrangements, and governmental Section 457 plans. (SEPs and SIMPLE-IRAs can be converted into Roth IRAs simply by recharacterizing the accounts into Roth status.)

As is the case for traditional IRAs, any RMDs coming out of qualified plan accounts cannot be rolled over into a Roth IRA.

As is the case for traditional IRAs, the rollover and conversion of a qualified retirement plan account balance is treated as a distribution from the retirement plan account followed by a nondeductible contribution to the Roth IRA . The deemed distribution from the retirement plan account will trigger a current federal income tax hit (and often a state income tax hit too), except in the rare case where the account is worth less than its tax basis from nondeductible contributions. (See IRS Notices 2008-30 and 2009-75.)

Roth Conversion Variables

In evaluating the Roth conversion strategy for a particular client, assumptions must be made, and someone must “run the numbers.” That someone should be you, and we will show you one way to do it later in this chapter. After running the numbers, the client must understand that the output only represents what might happen. In other words, we are talking about a projection here, not a glimpse into the future that the client can take to the bank. Put yet another way, the projected results of a Roth conversion are only as accurate as the underlying assumptions turn out to be. In reality, only one thing can be predicted with uncanny accuracy: a Roth conversion will almost always trigger an income tax bill that could otherwise be deferred.  With that thought in mind, here are the key variables to consider in assessing the wisdom of the Roth conversion strategy.

Tax Rates on Income Triggered by Conversion

When a Roth conversion is made, the taxable income from the resulting deemed traditional IRA distribution is piled on top of taxable income from all other sources. So, when the client converts a large IRA, it can push her into higher tax rate brackets (possibly much higher). In addition, the conversion income increases the client’s AGI, which can trigger a host of unfavorable AGl-based rules (such as the 3.8 percent Medicare surtax on net investment income, and the phase-out rules that can curtail the child tax credit, the higher education tax credits, the ability to currently deduct passive losses from rental real estate, and so forth).

The client need not immediately convert the entire balance in a large IRA. For instance, she can convert the balance in stages over several years. When the client has several traditional IRAs, she can choose to convert only the ones with modest account balances. You get the idea.

Impact of Nondeductible Contributions

A client who has made nondeductible contributions to his traditional IRA(s) may not understand that he cannot simply convert an amount equal to the cumulative nondeductible contributions and thereby avoid any conversion tax hit. Why? Because the client is considered to convert pro rata nontaxable and taxable amounts based on the aggregate balance of all his traditional IRAs, including any SEP-IRAs and SIMPLE-IRAs, and the aggregate amount of all nondeductible contributions to those accounts regardless of which account or accounts are actually converted.

Source of Cash to Pay Conversion Tax Hit

When a traditional IRA is converted into a Roth account, the cash to pay the conversion tax hit  must come from somewhere . However, it generally should not come from IRAs or other tax­ deferred retirement accounts. Why? Because if money is withdrawn from such accounts, including the account that is to be converted, the IRC Section 72(t) 10 percent early withdrawal penalty tax will usually apply if the account owner is under age 59½. The penalty tax will be in addition to the income tax hit on the conversion.

What if the client instead taps into her new Roth IRA after the conversion to get the cash needed to pay the conversion tax bill? In this case too, the 10 percent early withdrawal penalty tax will usually apply if the client is under age 59½. (See IRC Sec. 408A(d)(3)(F).) Of course, tapping into the Roth account would also have the negative effect of reducing the account balance, which means less tax-free income will be earned in the future. The whole idea of converting is to maximize the amount of tax-free income earned in the future.

For the reasons explained above, clients generally should consider Roth conversions only when they have enough available cash to pay the conversion tax hit without withdrawing money from tax-favored retirement accounts.

Expectations about Retirement-Age Tax Rates

This is where it gets interesting. The Roth conversion strategy makes the most sense when the client expects to be in relatively high-income federal income tax brackets during his retirement years. Why? Because those are the years during which the client would be taking taxable IRA withdrawals if the account under consideration were left in traditional IRA  status.  Put another way, converting the traditional IRA into a Roth IRA would allow the client to avoid paying high postretirement tax rates on earnings that accumulate in the account after the conversion.

On the other hand, the conversion strategy makes much less sense if the client expects to pay only 10 percent or 15 percent to the IRS during his retirement years.

The reduced tax rates established by the Tax Cuts and Jobs Act (TCJA) for 2018-2025 make the conversion strategy that much more attractive, especially when you consider that the rate reductions may turn out to have a relatively short shelf life.

Expectations about Retirement-Age Financial Position

The Roth conversion strategy makes more sense for clients who will not actually need to take IRA withdrawals during their retirement years. Such well-off individuals may instead prefer to leave their IRAs to their heirs. However, that is difficult to do with traditional IRAs, because the required minimum distribution (RMD) rules force account owners to begin taking RMDs after they reach age 72. With a Roth IRA, however, no RMDs are required until after the account owner dies. Plus, post-death withdrawals will be federal-income-tax-free to the heirs assuming the withdrawals meet the definition of qualified Roth distributions, which will usually be the case.

Expectations about Investment Rates of Return

The higher the expected rate of return on investments held in the client’s IRA, the better the case for conversion. In the absence of healthy future returns, a Roth conversion would simply mean the client prepaid income taxes for no good reason. That would not qualify as wise tax planning.

Planning for Conversions

Multiyear Conversion Strategy

As explained earlier, the taxable income triggered by a client’s Roth conversion is combined in with all her other ordinary income from salary, self-employment, and so forth. Therefore, converting a traditional IRA with a hefty balance could transport the client into significantly higher tax brackets. The taxable income triggered by the conversion will also bump up the client’s AGI, which could trigger a host of unfavorable AGl-based phase-out rules. To avoid these fates, clients can consider converting large traditional IRA balances into Roth status in stages over several years.

Concern:  The multiyear conversion strategy could turn out to be a really bad idea if tax rates go up in future years. Clients must place their bets and hope for the best.

Example:  Cindy is a married joint filer. She has a traditional IRA worth $300,000, mainly from rolling over qualified retirement plan distributions from several former jobs. Cindy expects the taxable income on her 2020 joint return to be about $170,000, before counting any additional income that would be triggered by a Roth conversion. Under these facts, Cindy’s 2020 marginal federal income tax rate is 24 percent, before considering any conversion income.

If Cindy converts the entire $300,000 balance in her traditional IRA in 2020, about half of the $300,000 will be taxed at 24 percent. The rest will be taxed at 32 percent and 35 percent. She may also be more exposed to the 3.8 percent Medicare surtax on net investment income (the NIIT) due to the additional income triggered by the conversion. If Cindy is expecting to pay her normal 24 percent marginal federal rate, she will be disappointed. Reporting an extra $300,000 of income could also trigger unfavorable AGl-based rules.

As an alternative, Cindy could choose to convert her traditional IRA balance in stages over several years (say $150,000 in 2020 and another $150,000 in 2021). Assuming no change in the current individual federal income tax rate structure, that would result in most or all of the income triggered by the conversions being taxed at 24%.

Split Large Traditional IRA Into Several Accounts Before Converting

Say the client has a big traditional IRA that he wants to convert into a Roth account. He should consider splitting the one big account up into several smaller accounts before converting them all into separate Roth IRAs. This can be done via tax-free direct (trustee to trustee) transfers from the original traditional IRA into new traditional IRAs followed by converting the traditional IRAs into Roth accounts. Then he can follow different investment strategies for each of the Roth accounts.

Bottom Line on Roth Conversions 

Evaluating the wisdom of doing a Roth conversion depends on assessing several client-specific factors. Conversions generally do not make much sense unless the client: (1) expects to pay the same or higher tax rates during retirement, (2) expects to leave the Roth IRA money invested for long enough and at a high enough rate of return to more than recover from the upfront conversion tax hit, and (3) can afford to pay the conversion tax hit from sources other than withdrawals from tax-favored retirement accounts. If these basic criteria are met, now is the perfect storm for Roth conversions.

 

Roth Conversion Contributions for Non-spousal Qualified Retirement Plan Beneficiaries

When a qualified retirement plan participant passes away, some individual beneficiary will usually inherit the retirement plan account balance. That individual may be someone other than a surviving spouse.

Changes included in the Pension Protection Act of 2006 allow a non-spousal qualified plan beneficiary to transfer an inherited balance into a Roth IRA and thereby effect a Roth conversion. (See IRC Secs. 408A(e)(l) and 402(c)(ll), IRS Notice 2008-30, Q&A-7, and IRS Notice 2009-75.) We will call such transfers Roth IRA conversion contributions.

For non-spousal qualified plan beneficiaries, the Roth conversion contribution privilege is important since they have no other way to get large amounts of inherited retirement account money into Roth IRAs. That is because non-spousal beneficiaries of traditional IRAs cannot make Roth conversion contributions with their inherited balances. (See IRC Secs. 408A(e)(l)(B)(i) and 408(d)(3)(C) and Reg. 1.408A-4, Q&A-1.)

Note:  Before 2010, individuals with modified adjusted gross income (MAGI) above $100,000 were ineligible for Roth conversion contributions, as was anyone who used married filing separate status (regardless of MAGI). Those restrictions are now history. With the Roth conversion playing field wide open, the issue of conversion contributions by non-spousal qualified plan beneficiaries is now more important than ever.

Note: Starting with plan years beginning in 2010, plans must permit non-spousal qualified plan beneficiaries to transfer inherited balances into receiving Roth IRAs.

Basics on Nonspousal Conversion Contributions from Qualified Plans

The non-spousal qualified plan beneficiary conversion contribution privilege is available for inherited balances from profit-sharing plans, 40l(k) plans, 403(a) plans, 403(b) plans, and governmental 457(b) plans. (See IRS Notice 2008-30, Q&A-1 and -2 and IRS Notice 2009-75.) However, required minimum distribution (RMD) amounts cannot be contributed.

For a non-spousal qualified plan beneficiary, a conversion contribution can only be accomplished  via a direct trustee-to-trustee transfer  from the qualified  plan into a new Roth IRA set up specifically to receive the conversion contribution. The funds cannot pass through the beneficiary’s hands. For purposes of this discussion, we will call the new Roth account the receiving Roth IRA.  The nonspousal beneficiary must report the  taxable  portion of the conversion  contribution  as gross income, including the amount of any net unrealized appreciation of employer securities that are transferred from the plan to the receiving Roth IRA as part of the conversion contribution. (See Notice 2009-75, Q&A-1.)  The receiving Roth IRA must be titled in the name of the deceased qualified plan participant, but it will effectively be under the nonspousal beneficiary’s control. For example, the receiving Roth IRA might be titled “Mega Bank, Custodian, for IRA of Steven Stiff, Deceased, Danny Stiff, Beneficiary” or something to that effect. (See Notice 2008-30, Q&A-7 and Notice 2007-7, Q&A- 13.)

Note:  Because the receiving Roth IRA is treated as an inherited IRA for required minimum distribution purposes, it can only contain the funds from the deceased qualified plan participant’s account.

RMD Rules for Inherited IRAs Apply to Receiving Roth IRA

The receiving Roth IRA is subject to the required minimum distribution (RMD) rules for inherited IRAs. Specifically, the rules that apply when an IRA owner dies before the RMD required beginning date (RBD) must be followed. (The RBD is April 1 of the year after the year during which the IRA owner turns age 70½.)

Under those rules, the non-spousal beneficiary must take his initial RMD from the receiving Roth IRA by no later than December 31 of the year following the year of the qualified plan participant’s death. For each subsequent year, another RMD must be taken by the end of that year. This assumes the beneficiary is allowed to use the taxpayer-friendly beneficiary’s life expectancy method to calculate RMDs, as opposed to being forced to follow the unfavorable five-year rule for RMDs. In the context of a receiving Roth IRA, being stuck with the five-year rule is rather disastrous, because it brings a premature end to the account’s tax-free advantage. (See Notice 2008-30, Q&A-7; and Notice 2007-7, Q&A-17, -18, and -19.)

Qualified Distributions from Receiving Roth IRA are Federal Income Tax Free

Withdrawals from the receiving Roth IRA, including withdrawals taken to satisfy the RMD rules, are federal-income-tax-free if they are qualified distributions. A qualified distribution is one that is taken after the taxpayer: (1) has had at least one Roth IRA open for over 5 years, and (2) has reached age 59½ or is dead or disabled. After the taxpayer has met the 5-year requirement, a qualified distribution can also be taken to cover eligible principal residence acquisition costs subject to a lifetime maximum of $10,000 for such costs. (See IRC Sec. 408A(d)(2)(A).)

In the case of a receiving Roth IRA funded with a conversion contribution from an inherited  qualified plan balance, the second requirement has already been met. Therefore, the only issue is satisfying the five-year rule. The five-year period starts on January 1 of year for which the deceased qualified plan participant made his earliest Roth IRA contribution.

For example, assume the deceased participant’s first Roth account was established by making a regular annual contribution for the 2015 tax year in April of 2016. The 5-year clock for the nonspousal beneficiary to be able to take qualified distributions from the receiving Roth IRA started ticking on January 1, 2015 (January 1 of the tax year for which the contribution to the deceased participant’s first Roth IRA was made). (See Reg. 1.408A-6, Q&A-7.)

However, if the deceased plan participant never made a Roth contribution, the five-year clock presumably starts ticking on January 1 of the year during which the nonspousal beneficiary makes the conversion contribution into the receiving Roth IRA. For example, with a 2020 conversion contribution, the clock would apparently start ticking on January 1, 2020.

Note: The nonspousal beneficiary can always take tax-free withdrawals from the receiving Roth IRA up to the amount of the conversion contribution. Therefore, RMDs taken from that account will almost always be tax-free even if the five-year rule for qualified distributions has not yet been satisfied.

Ten Percent Early Withdrawal Penalty Does Not Apply to Early Withdrawals from Receiving Roth IRA

Because the receiving Roth IRA is treated as an inherited Roth IRA, withdrawals  by the  nonspousal beneficiary will never be subject to the 10 percent early withdrawal penalty tax, even if the beneficiary is under age 59½. (See IRC Sec. 72(t)(2)(A)(ii).)

How To Handle Roth IRA Withdrawals

Clients who own Roth IRAs may be under the mistaken impression that withdrawals are always federal-income-tax-free. Not true. Even worse, some withdrawals can get socked with a 10 percent early withdrawal penalty tax.

Qualified Withdrawals Are Always Tax-Free

If you: (1) are at least age 59½ (or disabled or dead), and (2) have had at least 1 Roth IRA open for over 5 years, all withdrawals from any of your Roth accounts are qualified withdrawals. As such, they are automatically federal-income-tax-free and penalty-tax-free.  However, you must pass both the age-59½ test and the 5-year test to be eligible for qualified withdrawals.  The 5-year period for determining if you pass the 5-year test begins on January 1 of the first tax year for which you make a Roth contribution. It can be a regular annual contribution or a conversion contribution.

Example 1 (Earliest Date for Qualified Withdrawals)

Jorge established his first Roth IRA (Roth IRA-1) with a regular annual contribution on April 15, 2017. The contribution was for the 2016 tax year. His five-year period started on January 1, 2016, even though his initial contribution was actually made in 2017.  Therefore, anytime on or after January 1, 2021, Jorge can take federal-income-tax-free qualified withdrawals from any Roth IRAs that he owns – as long as he is 59½ or older on the withdrawal date.  Jorge opened a second Roth account (Roth IRA-2) in 2018 by converting a traditional IRA.  No matter how many Roth accounts Jorge owns, there is only one starting date for the five-year period. Therefore, he can take tax-free qualified withdrawals from either Roth IRA-1 or Roth IRA-2 (or both) anytime on or after January 1, 2021 – as long as he is at least 59½ on the withdrawal date.

Tax Reporting for Qualified withdrawals

If you take a qualified withdrawal, you should receive a Form 1099-R from the Roth IRA trustee shortly after the end of the year when the withdrawal was taken. Box 1 of the Form 1099-R should report the total amount of withdrawals for the year. Often Box 2b will be checked to indicate the trustee has declined to determine the taxable amount (if any). However, if the trustee believes it was a qualified withdrawal, Box 2a could report a taxable amount of zero. If the trustee knows the withdrawals were qualified withdrawals, Box 7 of Form 1099-R should contain the letter Q (the reporting code for qualified distributions).

On your Form 1040 for the withdrawal year, report the total amount of qualified withdrawals on line 4a. Then report zero on line 4b (taxable amount), because qualified withdrawals are federal income tax free. (This assumes the appropriate lines on the 2020 Form 1040 will be the same as on the 2019 version.)

Nonqualified Withdrawals Fall Under Complicated Tax Rules

Nonqualified Roth IRA withdrawals are potentially subject to federal income tax. In addition, early-nonqualified withdrawals (that is, those taken before age 59½) are potentially subject to a 10 percent early withdrawal penalty tax.

Nonqualified withdrawals can occur in 2 basic scenarios: (1) when you take withdrawals before age 59½, and (2) when you take withdrawals before passing the five-year test.

Scenario 1:  Withdrawals are Nonqualified Because They Are Taken before Age 59 1/2

Any Roth withdrawal taken before age 59½ is a nonqualified withdrawal by definition unless you are: (1) disabled, (2) dead, or (3) eligible for the special first-time home purchase rule explained later.  Nonqualified withdrawals are potentially subject to: (1) federal income tax, and (2) a 10 percent early withdrawal penalty tax. You may owe a state income tax bill too.

Nonqualified withdrawals can potentially come from four different layers, and different tax rules apply to each layer. Complicated? You bet. All will become clear if you keep reading.

Note:  If you own several Roth IRAs, you must aggregate them and treat them as a single account for purposes of determining which layer(s) withdrawals come from and the resulting tax consequences. (See IRC Sec. 408A(d)(4) and Reg. 1.408A-6, Q&A-8.) If your spouse owns one or more Roth IRAs, that does not affect how withdrawals from your Roth IRAs are taxed. In other words, the tax rules for Roth withdrawals are applied separately to your accounts and to your spouse’s accounts.

Rules for Withdrawals from Layer 1 (Annual Contribution

When you take nonqualified withdrawals, they are treated as coming first from Layer No. 1, which consists of the total amount of your annual Roth contributions. Withdrawals from Layer No. 1 are always federal income tax free and penalty free.

To determine how much you have in Layer No. 1, add up the total annual contributions to all Roth IRAs set up in your name and subtract any withdrawals from Layer No. 1 taken in previous years. This calculation is made by filling out Part Ill  of Form 8606 (Nondeductible IRAs). Include  the Form 8606 with your Form 1040 for the withdrawal year.

Rules for Withdrawals from Layer No. 2 (Taxable Portion of Conversion Contributions)

After you have exhausted Layer No. 1, any additional nonqualified withdrawals are treated as coming first from Layer No. 2, which consists of the taxable portion of any Roth conversion contributions you have made over the years.

Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution (for example, from a 40l(k) account) to a Roth IRA. The taxable portion of a conversion contribution is the amount of taxable income triggered by that contribution.

To determine how much you have in Layer No. 2, review your tax returns, and add up all the taxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals from Layer No. 2 taken in previous years. This calculation is made by filling out Part Ill of Form 860 6. Include the Form 8606 with your Form 1040 for the withdrawal year.

Withdrawals from Layer No. 2 are always federal income tax free. However, you will be hit with a 10 percent early withdrawal penalty tax on any amount withdrawn from Layer No. 2 within five  years of the conversion contribution unless you are eligible for one of the IRA exceptions to the penalty tax. The five-year period starts on January 1 of the year during which you made the conversion contribution. If you made several conversion contributions, you must use the first-in­ first-out (FIFO) principle to determine which conversion contribution each withdrawal comes from. (See IRC Secs. 408A(d)(3)(F) and 72(t) and Reg. 1.408A-6, Q&A-8.)

If you owe the 10 percent early withdrawal penalty tax, complete Form 5329 (Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Plans) and include it with your Form 1040. Enter the penalty tax amount on the appropriate line on page 2 of Form 1040.

Rules for Withdrawals from Layer No. 3 (Nontaxable Portion of Conversion Contributions)

After you have exhausted Layer No. 1 and Layer No. 2, any additional nonqualified withdrawals are treated as coming first from Layer No. 3, which consists of the nontaxable portion of any Roth conversion contributions. Conversion contributions can come from converting a traditional IRA into a Roth account or from contributing a retirement plan distribution (for example, a 401(k) account) to a Roth IRA. The nontaxable portion of a conversion contribution is the amount of nondeductible contributions included in that contribution.

Withdrawals from Layer No. 3 are always federal income tax free and penalty free.

To determine how much you have in Layer No. 3, review your tax returns and add up all the nontaxable conversion contributions to all Roth IRAs set up in your name. Then subtract any withdrawals from Layer No. 3 taken in previous years. This calculation is made by filling out Part Ill of Form 860 6. Include the Form 8606 with your Form 1040 for the withdrawal year.

Rules for Withdrawals from Layer No. 4 (Account Earnings)

After you have exhausted Layers 1 through 3, any additional nonqualified withdrawals come from Layer No. 4, which consists of Roth IRA earnings.

Nonqualified withdrawals from Layer No. 4 are always 100 percent taxable. Complete Part Ill of Form 8606 to calculate the amount from Layer No. 4, and include the Form 8606 with your return.

You will also be hit with a 10 percent early withdrawal penalty tax on any amount withdrawn from Layer No. 4 unless you are eligible for 1 of the IRA exceptions to the penalty. (See IRC Secs. 408A(d)(2) and 72(t) and Reg. 1.408A-6, Q&A-5.) If you owe the 10 percent early withdrawal penalty tax, complete Form 5329 and include it with your Form 1040. Enter the penalty amount on the appropriate line on page 2 of Form 1040.

Example 2 – Tax Consequences of Early Withdrawals

Way back in 2014, Ann (now age 51), converted her traditional IRA worth $30,000 into a Roth account. Assume the entire conversion contribution amount was taxable (that is, Ann had not made any nondeductible contributions to the traditional IRA).

In early 2016, Ann made a $2,000 annual after-tax contribution to the same Roth account for the 2015 tax year.  Since then she has made no further Roth contributions.  Assume Ann withdraws $15,000 in 2020. At the time of the withdrawal, the Roth account balance is $54,000.

Under the ordering rules for Roth withdrawals, the first $2,000 is treated as coming from Ann’s annual after-tax contribution for the 2015 tax year (Layer No. 1). That amount can be taken out at any time with no federal income tax and no 10 percent penalty.

The remaining $13,000 is considered a partial withdrawal of the $30,000 taxable conversion contribution amount from 2014 (Layer No. 2). Since Layer No. 2 was taxed in 2014, the withdrawal is federal-income-tax-free. Since the withdrawal occurs after the end of Ann’s 5-year period for worrying about the 10 percent penalty, (the five-year clock started ticking on January 1, 2014), the $13,000 withdrawal is also free of the 10 percent penalty.

Therefore, Ann owes no federal income tax and no 10 percent penalty on her $15,000 withdrawal.

Withdrawing conversion contribution money within five years of the beginning of the conversion year is a bad idea unless an exception to the 10 percent penalty tax is available.

Example 3 – Early Withdrawals Can Be Hit with Both Income Tax & Penalty

Assume the same basic facts as in the preceding example, except this time assume Ann withdraws $35,000 in 2020. As before, assume her Roth IRA balance is $54,000  at the time of the withdrawal.

As in the preceding example, the first $2,000 is deemed to be a federal-income-tax­ free and penalty-free withdrawal of Ann’s annual after-tax contribution for the 2015 tax year (Layer No. 1).

The next $30,000 is deemed to come from the 2014 taxable conversion contribution (Layer No. 2). That $30,000 comes out federal income tax free. It also comes out free of the 10 percent penalty since Ann’s five-year period expired before the withdrawal.

The final $3,000 comes from account earnings (Layer No. 4), because all  of Ann’s $32,000 of annual and conversion contributions have been withdrawn. The entire $3,000 from Layer No. 4 must be included in Ann’s 2020 gross income, because she is not age 59½, dead, disabled, or using the money for qualified home acquisition costs (see below). The entire $3,000 is also hit with the 10 percent penalty unless Ann qualifies for an exception to the penalty (assume she does not).

The $3,000 taxable amount should be reported on Ann’s 2020 Form 1040, and the 10 percent penalty of $300 should be reported on the appropriate line. Ann’s return should include completed Forms 8606 and 5329.

 

Scenario 2:  Withdrawals are nonqualified Because Account Owner Did Not Pass Five-Year Test

Any Roth withdrawal taken before passing the five-year test is a nonquafified withdrawal by definition (no exceptions). Nonqualified withdrawals are potentially subject to: (1) federal income tax, and (2) a 10 percent early withdrawal penalty. You may owe a state income tax bill too.

Scenario 2 nonqualified withdrawals are generally handled under the same 4-layer system that applies to Scenario 1 nonqualified withdrawals.

The major difference between Scenario 1 nonqualified withdrawals and Scenario 2 nonqualified withdrawals is that Scenario 2 withdrawals will never be hit with the 10 percent early withdrawal penalty if you are age 59½ or older. However, if you are younger, you will owe the penalty unless you are eligible for one of the IRA exceptions.

If you own several Roth IRAs, you must aggregate them and treat them as a single account to determine which layer(s) each nonqualified withdrawal comes from and the resulting tax consequences. (See IRC Sec. 408A(d)(4) and Reg. 1.408A-6, Q&A-8.) If your spouse owns one or more Roth IRAs, that does not affect how withdrawals from your Roth IRAs are taxed. In other words, the tax rules for Roth withdrawals are applied separately to your accounts and to your spouse’s accounts.

Example 4 – Tax Consequences of Failing the Five-Year Test

In early 2016, Theo converted a traditional IRA worth $90,000 into a Roth account. Assume the entire $90,000 was a taxable conversion contribution (Layer No. 2), because he had not made any nondeductible contributions to the traditional IRA.

In early 2019, Theo made a $5,000 annual contribution to the same Roth IRA (Layer No. 1). The contribution was for his 2018 tax year.

In 2020, Theo withdraws $105,000. At the time of the withdrawal, his Roth balance was $150,000.

Assume Theo is over age 59½.

The first $5,000 of his withdrawal is treated as coming from Layer No. 1 (annual contributions). The entire $5,000 comes out federal income tax free and penalty free. The next $90,000 is treated as coming from Layer No. 2 (taxable conversion contributions). The entire $90,000 comes out federal income tax free. Theo does not owe the 10 percent penalty, because he is over age 59½.  The final $10,000 comes from Layer No. 4 (account earnings). Because the five-year test is failed, the entire $10,000 must be reported as gross income on Theo’s 2020 Form 1040. He does not owe the 10 percent penalty, because he is over age 59½.

Tax Reporting for Nonqualified Withdrawals

If you take a nonqualified withdrawal, you should receive a Form 1099-R from the Roth IRA trustee shortly after the end of the year when the withdrawal was taken.

Box 1 of the Form 1099-R should report the total amount of withdrawals for the year. Usually Box 2b will be checked to indicate that the trustee has declined to determine the taxable amount (if any). However, if the trustee knows the taxable amount, it could be reported in Box 2a.

If the trustee thinks the withdrawals were nonqualified withdrawals subject to the 10 percent penalty, Box 7 of Form 1099-R will contain the letter J (the code for early distributions).

If the trustee knows you do not owe the 10 percent penalty, because you are age 59½ or older, disabled, or dead, Box 7 of Form 1099-R will contain the letter T (the code when an exception to the 10 percent penalty applies).

On your Form 1040 for the withdrawal year, report the total amount of nonqualified withdrawals on line 4a. Report any taxable nonqualified withdrawals on line 4b. As we explained earlier, Form 8606 is completed to determine if any of your nonqualified withdrawals are taxable. Include Form 8606 with your return.

If you owe the 10 percent penalty tax, complete Form 5329 and include it with your return. Enter the penalty tax amount on the appropriate line on Page 2 of Form 1040.

Special Home Purchase Rule for Under-Age 59½ Account Owners

After you have passed the 5-year test, a special rule allows federal income tax free and penalty   free Roth withdrawals to the extent of money you spend within 120 days to pay qualified principle residence acquisition costs . However, there is a $10,000 lifetime limit on this special rule. (See IRC Secs. 408A(d)(5) and 72(t)(2)(F) and (t)(8).)

This special provision is only available when the account owner has passed the five­ year test.

To the extent the special rule applies to a withdrawal, the eligible amount is treated as a qualified withdrawal (that is, it is federal income tax free and penalty free).

The principal residence can be acquired by: (1) you as the account owner; (2) your spouse; (3) your child, grandchild, or grandparent; or (4) your spouse’s child, grandchild, or grandparent. The homebuyer, and the buyer’s spouse if the buyer is married, must not have owned a principal residence within the two-year period that ends on the acquisition date. Qualified acquisition costs are defined as costs to acquire, construct, or reconstruct a principal residence – including closing costs.

When you take a withdrawal that qualifies for this special rule, you should receive a Form 1099-R from the Roth IRA trustee shortly after the end of the year when the withdrawal was taken. Box 1 of the Form 1099-R should report the total amount of the withdrawal. Box 7 of Form 1099-R may contain the letter J (the code for early distributions) if the trustee (wrongly) thinks you owe the 10 percent penalty tax because you were not 59½ or older on the withdrawal date.

To take advantage of the special home purchase rule, enter your total Roth withdrawals for the year on line 4a of Form 1040. Then enter your qualified home purchase expenses (subject to the

$10,000 lifetime limit) on line 20 of Form 8606. Complete Form 8606 to determine the taxable amount (if any) to report on line 4b of Form 1040. Include Form 8606 with your return.

Conclusion

While the tax rules for nonqualified Roth withdrawals are complicated, everything falls in place when you properly complete Part Ill of Form 8606 and report the proper taxable amount on line 4b of Form 1040. You must also fill out Form 5329 if the 10 percent penalty tax applies and enter the penalty tax amount on the appropriate line on page 2 of Form 1040.

Important:  After the end of any year you take Roth withdrawals, you should receive a Form 1099-R from the Roth trustee or custodian. It shows the total amount of withdrawals for the preceding year, and the IRS gets a copy. So, if you took any nonqualified withdrawals, the Feds will expect to see Form 8606 included with your return.

 

Alternatives to Now-Seriously-Wounded Stretch IRA Estate Planning Strategy

The Setting Every Community Up for Retirement Enhancement Act (the SECURE Act) became law in late 2019. The SECURE Act was mainly intended to expand opportunities for people to increase their retirement savings. Fine. But it also included one big anti-taxpayer  change that kneecapped the so-called Stretch IRA strategy that was employed by many well-off IRA owners. The kneecapping change is the 10-year account liquidation rule that now applies to IRAs that are inherited after 2019 by most  non-spouse  beneficiaries. We fully explain  that unfavorable  change in Chapter 5. In this Hot Topic, we will cover some tax-smart estate planning alternatives  for well­ off folks who would have loved to use the Stretch IRA strategy but no longer can, thanks to the SECURE Act. Here goes.

Federal Gift and Estate Tax Regime for 2020

For 2020, the unified federal gift and estate tax exemption is a whopping $11.58 million or effectively $23.16 million for a married couple (IRC Sec. 2010 and Rev. Proc. 2019-44). The huge exemption is thanks to the Tax Cuts and Jobs Act (TCJA).

For 2020, cumulative lifetime gifts and estate values in excess of the exemption amount are taxed  at a flat 40% rate, which is a low rate by historical standards.

For 2020 and as long as the TCJA federal gift and estate tax regime remains in place, relatively few individuals will be exposed to federal gift or estate taxes. Therefore, it’s appropriate to look at strategies that can reduce income taxes, which affect almost everybody. So, let’s focus on wealth­ transfer strategies that: (1) can reduce or postpone federal income taxes (and often state income taxes too, depending on the jurisdiction) and (2) will generally not do any harm under the federal gift and estate tax regime that is in place for 2020. Here goes.

Post-SECURE-Act Strategy: Set up Roth IRA and Live with 10-Year Account Liquidation Rule

As explained in Chapter 5, the SECURE Act establishes a new 10-year account liquidation rule for most non-spouse beneficiaries of IRAs inherited from account owners who die after 2019. While this is not a positive estate planning development, it’s not such bad news in the context of Roth IRAs. That’s because Roth IRAs left to non-spouse beneficiaries can still earn federal-income-tax­ free income and gains for as long as the account owner lives and for at least 10 years thereafter.

That can work out OK, as the example later in this analysis illustrates.

Roth IRA Tax Advantages

It is important to remember that the Roth IRA actually has two big advantages over the traditional IRA as a tax-favored wealth transfer vehicle.

Advantage No. 1: Tax-Free Withdrawals

The first and biggest advantage is the fact that qualified distributions from a Roth IRA are completely free of any federal income tax under current law. As long as all Roth withdrawals are qualified distributions, the account owner or beneficiary will never owe the IRS dime in taxes on those withdrawals.

Qualified Roth distributions are those that are taken after: (1) the original account owner has reached age 59½, died, or become disabled and (2) the original account owner has had at least one Roth IRA established in his or her name open for at least five years. Withdrawals from an inherited Roth IRA that meets these two requirements will be tax-free qualified distributions.

If your client leaves a Roth IRA to a non-spouse beneficiary, the beneficiary can continue accumulating tax-free earnings for at least 10 years and can take a federal-income-tax-free qualified distribution to liquidate the account at the end of the day. [See IRC Secs. 401(a)(9) and 40 8A.] For full details on the SECURE Act 10-year account liquidation rule and the exception for eligible designated beneficiaries, see Chapter 5.

Advantage No. 2: Exemption from Dreaded RMD Rules

An original Roth IRA owner need not take any annual required minimum distributions (RMDs) from the account, because the RMD rules do not apply for as long as the original account owner lives [IRC Sec. 408A(c)(4)].

Favorable Rule for Spousal Roth IRA Beneficiaries

If your client leaves a Roth IRA to his or her surviving spouse as the sole account beneficiary, the spouse can retitle the account and treat it as his or her own Roth IRA. Then, the spouse need not take any RMDs for as long as he or she lives.

Non-Spouse Roth IRA Beneficiaries Can Still Benefit Big-Time

When a non-spouse beneficiary (such as your client’s child or grandchild) inherits the client’s Roth IRA after 2019, the beneficiary  generally must liquidate the account within 10 years after the client’s death. While this rule is unfavorable compared to what was allowed before the SECURE Act, the fact is that many non-spouse beneficiaries will want to liquidate their inherited Roth balances within 10 years anyway. For those folks, the 10-year account liquidation rule does not matter.

Fund Roth IRA by Converting Traditional IRA

Usually, the only way to quickly get a substantial amount of money into a Roth account is by converting an existing traditional IRA into a Roth IRA. Of course, the client must pay a tax price for jump-starting a Roth IRA savings program. Even so, a conversion will often be worth the price.

A Roth conversion is treated as a taxable distribution from the converted traditional IRA. The client is deemed to receive a taxable payout from the traditional IRA, with the funds then going into the new Roth account. Therefore, the conversion usually triggers an income tax hit. In most cases, however, this negative factor is outweighed by the following positive factors.

• The client may be able to significantly reduce the income tax cost of converting a large traditional IRA (say one worth several hundred thousand dollars or more) by spreading the conversion process over several Current tax law allows this, and now is the best time to get started if the client believes current tax rates are probably lower than future tax rates.
• The conversion can position the client to use the new Roth IRA as a tax-smart wealth transfer vehicle as the example below
• By paying the conversion tax bill, the client is effectively prepaying future income taxes for the Roth account beneficiary, so the beneficiary can reap federal-income-tax-free earnings in the future, as illustrated in the example

Roth IRA as Wealth Transfer Vehicle.

Bob, is 65 when he converts his traditional IRA into a Roth account. He lives 12 more years and never takes any withdrawals.

Bob’s wife Carly is 70 when Bob dies. Carly inherits Bob’s Roth IRA as the sole designated account beneficiary. According to the current IRS life expectancy table, she can expect to live another 17 years . She treats the inherited Roth IRA as her own account, which means she need not take any RMDs during her lifetime. Assume she leaves the inherited Roth IRA untouched.

At age 87, Carly passes away and leaves the Roth IRA to daughter Darla, who was designated as the new account beneficiary when Carly took over the account. Darla is 50 years old. She must liquidate the account within 10 years after Carly’s death, but Darla is not required to take any withdrawals before that deadline. Under current law, any withdrawals taken by her will be federal-income-tax-free qualified distributions. Since Darla is tax-savvy like her parents, she withdraws nothing until she hits the 10- year account liquidation deadline.

In this example, following the Roth IRA strategy allowed the family to accumulate federal-income-tax-free earnings for 39 years: 12 years with Bob, 17 years with Carly, and 10 years with Darla. Not bad!

In effect, Bob and Carly took advantage of the Roth IRA strategy to establish a federal­ income-tax-free source of wealth for Darla, a member of the next generation.

Fund Roth IRA by Making Annual Non-Deductible Traditional IRA Contributions and Doing Annual Conversions

There is no AGI restriction on making non-deductible traditional IRA contributions. All you need is earned income at least equal to the contribution amount. That earned income can come from the client and/or the client’s spouse if the client is married.

For 2020, you can contribute up to $6,000 or $7,000 if you are age 50 or older. For 2020 and beyond, you can make traditional IRA contributions even after reaching age 70½, thanks to a favorable SECURE Act change [IRC Sec. 219(d)(l)]. Ditto for spouses of married clients.

So, clients can make annual non-deductible contributions to a traditional IRA and then immediately convert the account into a Roth IRA at no tax cost if the following warning is N/A. Therefore, a married couple can potentially get up to $14,000 annually into Roth IRAs in this fashion.

Non-deductible contributions to a traditional IRA give you tax basis in the account that can be withdrawn tax-free. But when you have one or more existing traditional IRAs that include deductible contributions and/or account earnings, a portion of any distribution  from any traditional IRA will be taxable [IRC Secs. 72(e)(3)(A)(ii) and 408(d)]. So, in that situation, if you make a non-deductible traditional IRA contribution and then convert the account to a Roth, you will trigger taxable income (because converting any traditional IRA triggers a deemed distribution from that account that will be partially taxable). Therefore, the non-deductible contribution followed by conversion into a Roth account drill will not be tax-free for everybody. However, if you do the drill after converting any traditional IRAs into Roth accounts, you won’t have any traditional IRA balances to worry about. So, you can now make annual non-deductible contributions and then effectively convert those contributions into Roth account status. That is a federal-income­tax-free strategy.

Other Wealth Transfer Strategies

Beyond the idea of using a Roth IRA as an intergenerational wealth transfer vehicle, there are other simple and easy wealth transfer strategies. Here are some for clients to consider.

• Make Big Gifts to Fund Section 529 College Savings Accounts
• Make Gifts to Fund Coverdell Education Savings Accounts
• Pay College Tuition Expenses (Not Room and Board) and/or Medical Bills for Loved Ones
• Make Outright Gifts to Loved Ones
• Buy Home for Loved One
• Buy Life Insurance to Transfer Wealth Tax-Free

The annual federal gift tax exclusion for 2020 is $15,000. The exclusion can be adjusted periodically in $1,000 increments to account for inflation.

Make Big Gifts to Fund Section 529 College Savings Accounts

The client can make a lump-sum 2020 gift of up to $75,000 to fund a Section 529 college savings account set up for a child or grandchild (or any other college bound individual) and claim a federal gift tax exclusion for the full amount. This is five years’ worth of the standard $15,000 exclusion that normally applies to 2020 gifts. [See IRC Sec. 529(c)(2) and Rev. Proc. 2019-44.]

Taking advantage of this favorable gift tax rule allows you to quickly fund a Section 529 college account without using up any of your unified federal gift and estate tax exemption. For 2020, the exemption is $11.58 million, or effectively $23.16 million for a married couple (Rev. Proc. 2019-44).

If the client is married, the spouse can also use the favorable gift tax rule to make a separate 2020 gift of up to $75,000 to fund a Section  529 account  for a child or grandchild (or anyone else) without any federal gift or estate tax consequences.

As you know, Section 529 accounts have a big income tax advantage, because account earnings are allowed to accumulate federal-income-tax-free. Withdrawals to cover qualified college costs are federal-income-tax-free, too. So, the 529 account is another good inter-generational wealth transfer vehicle.

Make Smaller Gifts to Fund Coverdell Education Savings Accounts

The client may qualify to contribute to Coverdell Education Savings Accounts (CESAs) set up for college-bound beneficiaries. If so, the client can contribute up to $2,000 per year per beneficiary. Contributions are not allowed if the client’s AGI exceeds certain levels, but there is an easy way around this restriction. The client can give money for CESA contributions to a relative whose income is low enough to be unaffected by the AGI restriction. Then that person can open up the CESA and make the desired contributions on behalf of the client’s beneficiary . (See IRC Sec. 530.)

For example, say the intended beneficiary is the client’s grandson. The client can give the CESA contribution dollars to the grandson’s parent (the client’s adult child) who can in turn make the desired contribution on behalf of the granddaughter.

Pay College Tuition Expenses (Not Room and Board) and/or Medical Bills for Loved Ones

Your client can pay unlimited amounts for these purposes without any federal tax consequences­ as long as this is done by making payments directly to the college or medical service provider.  Ditto for the client’s spouse if the client is married. [See IRC Sec. 2503(e).]

Make Outright Gifts to Loved Ones

Under the annual federal gift tax exclusion privilege, your client can give away up to $15,000 during each and every year to as many individuals as desired without any adverse federal tax effects. Over time, making these so-called annual exclusion gifts (gifts up to the applicable annual exclusion) every year can substantially reduce the value of the client’s taxable estate, especially if appreciating assets such as stocks, shares of equity mutual funds, or real estate are given away.

Clients can also make gifts that exceed the $15,000 annual exclusion amount. No gift tax will be owed on these “excess gifts” until they surpass the lifetime gift tax exemption. For 2020, the exemption is a whopping $11.58 million. If the client is married, the spouse is entitled to a separate exemption.

The annual gift tax exclusion amount is adjusted periodically for inflation in $1,000 increments.

Buy Home for Loved One

If your client buys a home for a loved one (subject to the preceding gift tax considerations), that person will eventually become eligible for the IRC Section 121 principal residence gain exclusion of up to $250,000 or $500,000 for a married couple. That’s one of the most valuable personal tax breaks on the books.

Buy Life Insurance to Transfer Wealth Tax-Free

There is generally no federal income tax hit on life insurance death benefits. So, beneficiaries of a policy on the client’s life are allowed to receive death benefit proceeds totally free of any federal income tax. [See IRC Sec. lOl(a)(l).]

Conclusions on Living Without Stretch IRAs

There you have them: some tax-smart estate planning alternatives for well-off clients who would have gladly embraced the Stretch IRA strategy but no longer can after the SECURE Act.

Roth IRAs for Kids

Working at a tender age is an American tradition. Lots of kids do it over the summer, after school, and over the weekends. What is not so traditional is the notion of kids contributing to their own Roth IRAs. It should be a tradition, because it’s such a good idea. Here is the scoop in plain English.

All that’s required to make a Roth contribution is having some earned income for the year. Age is completely irrelevant. So, if your child earns some cash from a summer job, or part-time work after school, or whatever, the kid is entitled to make a Roth contribution.  For the 2020 tax year, your child can contribute the lesser of: (1) earned income, or (2) $6,000. These contribution limits apply equally to Roth IRAs and traditional IRAs, but the Roth alternative is the way kids should go in  most cases-for reasons that are explained later.

By making Roth contributions for just a few years during teenagerhood, your child can potentially accumulate a good sum of money by retirement age. (You don’t want to think about your baby with gray hair, but it will happen.)

Realistically, most kids won’t be willing to contribute the $6,000 maximum to a Roth IRA, even when they have enough earnings to do so. Be satisfied if you can convince the kid to contribute at least a meaningful amount each year. Here’s what could happen.

• Say your 15-year-old pays $1,000 into a Roth IRA each year for three years, starting this year. After 45 years (when your gray-haired “kid” is 60), the account would be worth over $25,000-assuming a 5% annual rate of return. If you assume a more-optimistic 8% return, the account would be worth about $89,0 00.
• Say your child contributes $1,500 for each of the three With a 5% annual rate of return, the Roth account would be worth about $38,000 in 45 years. At 8%, it would be worth about $132,000.
• If your kid contributes $2,500 for each of the three With a 5% return, the Roth account would be worth about $64,000 in 45 years. At 8%, the number jumps to a whopping $222,000.

These retirement-age accumulations are not trivial amounts, even though the contributions that got the ball rolling are modest.

Roth IRAs are Usually Better for Kids than Traditional IRAs

For a kid, contributing to a Roth IRA is usually a much better idea than contributing to a traditional IRA for several reasons.

First, your child can later withdraw all or part of the Roth contributions-without any federal income tax or penalty-to pay for college or for any other reason. (Roth earnings generally cannot be withdrawn federal-income-tax-free before age 59½.)

Even though Roth contributions can be withdrawn without any federal tax hit, the best strategy is to leave as much of the account balance as possible untouched until retirement age. That way, your child could accumulate the amounts mentioned earlier and never owe any federal income tax on those amounts. But if money must be withdrawn from a Roth IRA, it can be done tax-free up to the cumulative amount of contributions. Flexibility is a good thing.

In contrast, if your child contributes to a  traditional  deductible IRA, any subsequent  withdrawals will be taxed. Even worse, payouts before age 59½ will be hit with a 10% early withdrawal penalty tax, unless the money is used for certain IRS-approved reasons (one of which is to pay college costs, thankfully).

What about tax deductions for IRA contributions? Good question. Your child won’t get any for Roth pay-ins, but the kid probably won’t get any meaningful tax deduction for contributing to a traditional IRA either. That’s because an unmarried dependent child’s standard deduction will shelter up to $12,400 of earned income (for 2020) from federal income tax. Any additional income will be taxed at low rates. So, unless your child has enough income to owe a significant amount of tax (pretty unlikely), the theoretical advantage of being able to deduct traditional IRA contributions is mostly or entirely worthless to your child. Since deductibility of contributions is the only advantage of traditional IRAs Roth IRAs, the Roth option is almost always the best option.

Conclusion on Roth IRAs for Kids

Encouraging your working kid to make Roth IRA contributions is a great way to introduce the  ideas of saving and investing for the future. Plus, there are tax advantages. It’s never too soon for your child to learn about taxes and how to legally minimize them. After all, it’s basically a game, and kids love games.