Klitzman Law Group, PLLC

Is It a Good Idea to Convert IRA to a Roth?

Converting a traditional IRA (Individual Retirement Account) to a Roth IRA is a great move if you can swing it, says an article from U.S. News & World Report, “How to Convert to a Roth IRA.” The advantages to the account owner and heirs are considerable.

The Roth IRA grows tax-free, which is good for trimming taxes during retirement when income is usually limited. It’s only available to single tax filers earning less than $146,000 or $230,000 for people filing jointly. However, higher earners can use the Roth conversion to fund a Roth from a traditional IRA.

Financial advisors say people still working should make the conversion if they are in lower tax brackets than they will be during retirement.

A good time for the conversion is after you’ve retired and before you’re required to take RMDs (Required Minimum Distributions) from the traditional IRA. The goal is to save lifetime taxes. How does it work?

When transferring funds from a traditional IRA to a Roth, the account owner must pay taxes on the amount being transferred at their current income tax rate. However, once the conversion is made, those funds grow tax-free. Even better, when you take out qualified withdrawals in retirement, the withdrawals are tax-free.

Roth conversions are a good idea for people in lower income brackets with retirement savings in IRAs. People who might be taking unpaid leave or are unemployed may also benefit from lowered income levels.

The key benefit of a Roth conversion is reducing taxes. Contributions are made with after-tax dollars, which means account owners don’t receive any income tax deduction upfront, which is what happens with a traditional IRA. However, once you start taking withdrawals from a Roth, as long as you’re 59 ½ or older and the account has been open for at least five years, you’ll enjoy not paying taxes on those withdrawals.

There is more to appreciate about a Roth IRA. There are no Required Minimum Distributions, so you can take or not take withdrawals whenever it suits your budget. As your estate planning attorney will tell you, your heirs will not pay income taxes on withdrawals or distributions either.

Then there’s the “Backdoor Roth,” where high-income taxpayers may contribute to Roth IRAs even though their income is higher than the allowable amount. This is a little intricate, and you may want to speak with your estate planning attorney about it. You make a nondeductible contribution to a traditional IRA, then convert it to a Roth IRA. This must work with any other retirement and estate planning strategies.

There are some pitfalls. You’ll need cash to pay taxes on the conversion. If you’ve done the conversion when your income tax rates are high, it may not make sense. Do this when you’re in a lower-income tax bracket.

Last thought – if you plan to pay the taxes out of the account you’re converting, the conversion will be less valuable, as the funds to pay the taxes won’t be converted and enjoy years of tax-free growth.

Reference: U.S. News & World Report (July 19, 2024) “How to Convert to a Roth IRA”

Does Your Retirement Plan Include Moving to a Lower Tax State?

People have long moved from high-tax to low-tax states. However, this movement increased during the pandemic and continues today. The response from high-tax states has become aggressive, especially in cases where people maintain a home in two states and try to pay taxes only in the less costly state. A recent Forbes article issues a clear warning: “Beware The Tax Traps Spring On Those Who Move In Retirement.”

These states levy a tax on income, estate and sales taxes based on where people make their legal domicile. However, determining where you live isn’t quite as cut-and-dried as people think. Tax departments in high-tax states have amped up their residency audits. When the system sees someone who once filed an income tax return as a full-time resident begins filing as a part-time resident or doesn’t file, the state wants to ensure that it’s not missing out on any revenue.

A residency audit is conducted. It may consist of a questionnaire asking about where the person lives, asking them to provide information about their lifestyle and providing details about the property they own in both states.

An aggressive state will search property records and other public records for evidence of ongoing connections to the state. Social media has become part of this information gathering, no matter how private people may set their profiles.

If you’ve moved for retirement or enjoy the benefits of living in two or more states, you’ll need to choose a state and prove your legally established residence in that state. Ideally, you’ll do this long before the residency audit arrives.

Did you already receive a letter from a state tax authority asking questions? Chances are the state has already begun investigating your status. The letter might include a questionnaire, an interview request, or both.

If you haven’t yet moved, consider how you’ll respond to these questions:

• Where do you vote?
• Where are your cars, boats, or other vehicles registered?
• Do you belong to a house of worship, and if so, where is it located?
• Do you have an estate plan, and what address does it show?
• Where do you own property, and how much time do you spend at each location?
• Do you belong to any social clubs – country clubs, bowling leagues, gyms, or community groups?
• If you own a business or are an employee, where is your business or employer located?

You’ll need to demonstrate where you live and whether you’ve truly cut ties with your prior state of residence. A final word of advice: don’t go into a residency audit unprepared or unrepresented. The possibility of paying taxes in two states should motivate you to make any necessary changes.

Another detail to consider when moving to retirement is that an estate plan made in one state may not be valid in another state. A local estate planning attorney in your new domicile should be consulted to review your will, power of attorney, healthcare directives and other state-specific documents to ensure they will be effective in your retirement home.

Reference: Forbes (April 23, 2024) “Beware The Tax Traps Spring On Those Who Move In Retirement”

Can You Gift Money from a Retirement Account?

When preparing an estate plan, it’s easy to neglect charitable giving, especially if your main focus is to get the plan done most efficiently and move on to the next task on your list—like spring cleaning or gardening. However, a recent article from the Tri-Cities Area Journal of Business recommends a way to take care of charitable giving as part of your estate plan that won’t be overly burdensome: “Use retirement accounts to give to charity in your estate plan.”

An estate comprises different assets, which all have different characteristics. Some assets are distributed by a will, and others by the beneficiary designation on the account. Some are subject to income taxes for heirs, and others are not taxable. This info needs to be considered when preparing an estate plan.

If you choose to give pre-tax retirement accounts, those funds are typically subject to income tax when beneficiaries withdraw money from them. A pre-tax retirement account may be more expensive for heirs, especially if they are in a high-income tax bracket. The inheritance could also push them into a higher tax bracket.

Nonprofits are not subject to income tax and are grateful to receive pre-tax retirement assets.

Your estate plan consists of a last will and testament, powers of attorney and health care directives. Your estate includes different types of assets, and you’ll need to consider their value in light of their tax liabilities when creating an estate plan.

Beneficiary designations are usually used with life insurance policies and retirement accounts. They can be changed whenever you want, and you can name whoever you want to receive the accounts, except pensions governed by federal law. Those must go to your spouse and follow the rules of the pension custodian.

To understand this concept, let’s say a married couple has two children and a net worth of $1 million, which includes a $500,000 house, $100,000 in the bank and $400,000 in their retirement accounts. If they want 10% of their estate to go to a charity and the rest to their children, they could do the following:

• Write the amount or percent of the donation into their will and direct their executor to ensure funds are donated from their probate estate, or
• They can use the beneficiary designation on their retirement account to give a certain percentage to their children and charity.

The charity will receive $100,000 from the pre-tax assets, thereby preserving more nontaxable assets for their children. As assets change over time, they may need to change the percentage of the assets given through the retirement accounts. Assuming high marginal tax rates, by giving from their retirement accounts, their heirs will net a higher amount than if other assets were used to make the gift to the charity.

If your estate plan hasn’t included charitable giving, and this is an important part of your legacy, consult with an estate planning attorney to learn how to structure your estate plan and beneficiary designations to work together to achieve your goals.

Reference: Tri-Cities Area Journal of Business (April 15, 2024) “Use retirement accounts to give to charity in your estate plan”

IRS Postpones Required Withdrawals from Inherited Retirement Accounts

The latest from the IRS is good news for people who have inherited retirement accounts since 2020, according to The Wall Street Journal article “Heirs Get More Time to Keep Their Money in Inherited Retirement Accounts.” The IRS announced it was postponing enforcement of a law originally passed in 2019, then revisited in February 2022 when the IRS proposed a change to rules mandating RMDs.

The 2019 law required retirement account heirs to empty IRAs within ten years instead of over their expected lifetimes. This was a major change, eliminating the stretch IRA, which had been enjoyed for many years. The stretch IRA allowed IRA beneficiaries to keep money in inherited IRA accounts for extended periods, allowing the IRA to grow tax-free and giving heirs advantageous flexibility with the accounts.

In 2022, the IRS proposed rules mandating annual withdrawals during the ten-year period if the original account owner had started taking RMDs before they died. This put estate planning concerning IRAs in a tailspin. Most IRA heirs planned on letting the assets in the accounts grow for ten years, then emptying the account at the ten-year mark.

The IRS was apparently listening, since the proposed rules led to a great deal of complaints from both taxpayers and the financial services sector. The rules were already confusing, the proposed rules were even more restrictive, and no one knew what to do.

The recent announcement from the IRS said it won’t impose any penalties for missing the RMDs until the details of how inherited (or beneficiary) IRAs are finalized. The reprieve has been extended to December 31, 2024. Penalties are expensive, so this announcement has been met with great relief from IRA heirs and estate planning attorneys alike.

To illustrate, let’s say a 66-year-old person inherited a parent’s $200,000 IRA in 2020. If it weren't for the IRS relief through 2023, they would have had to use $26,000 of the IRA so far to pay taxes on the RMD, and the 2024 RMD would have been about $9,000.

The issues aren’t just for heirs knowing what to withdraw from accounts. For those with IRA accounts they plan on leaving to heirs, changing distribution rules may impact how they use or bequeath IRAs. Does it make more sense to convert a traditional IRA to a Roth IRA, where taxes are paid upfront and the distribution of beneficiary accounts is considerably less restrictive? Or should they spend the entire IRA and save other assets for heirs?

Estate planning attorneys will continue to help people navigate this and other IRA-related estate planning matters. The rules may change again. However, keeping your estate plan up to date to take advantage of changing rules is the best approach to safeguarding your legacy.

Reference: The Wall Street Journal (April 17, 2024) “Heirs Get More Time to Keep Their Money in Inherited Retirement Accounts”