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Roth IRAs: A tool for wealth transfer across generations

Maria Bruno

Maria Bruno

In this podcast, Maria Bruno of Vanguard Investment Strategy Group discusses how Roth IRAs can be effective for transferring wealth to your loved ones spanning multiple generations. She shares points to consider as you determine whether a Roth IRA can help you achieve—or amplify—your wealth transfer goals.

An episode from Vanguard’s Investment Commentary podcast series



Diane Streleckis: Hello, and welcome to Vanguard’s Investment Commentary Podcast series. I’m Diane Streleckis. In this month’s episode, which we’re taping on March 30, 2016, we’ll explore another use for the Roth IRA, known so well as a retirement savings vehicle. Maria Bruno with Vanguard Investment Strategy Group is here to shed some light on how a Roth IRA can help you achieve, or even amplify, your wealth transfer goals. Hello, Maria, and thanks for joining us.

Maria Bruno: Thanks, Diane. It’s good to be here.

Diane Streleckis: Roth IRAs are popular choices for retirement savings, but what makes then effective tools to pass down wealth to loved ones?

Maria Bruno: There are many similarities, Diane, although when you start thinking about it from an estate planning standpoint, it does get a little bit more complicated in terms of understanding the options and the tradeoffs. But let’s talk a little bit about the benefits.

First, the benefit of tax diversification. So we talk about this a lot. By holding different account types—taxable, tax deferred, and Roth accounts—in your portfolio, it really gives you the most flexibility today but also as a hedge in the future against the direction of future income tax rates.

It really affords a lot of flexibility both to meet your goals in retirement, for instance, but also which assets potentially to pass to your heirs.

When you think about tax diversification, there’s basically two ways to achieve that. One, if you’re still working, then you can make contributions to your accounts and be strategic in terms of where you make the contributions, whether they’re tax deferred, traditional accounts, or Roth accounts, for instance.

But when you’re retired, you really then have to think about whether a Roth conversion can fit into your financial plan because at that point you’re not working and you can’t make contributions to an IRA. So, really, your options are limited to a conversion.

When you think about conversions, I think especially from an estate-planning standpoint, there’s really an opportunity here to maximize the after-tax value of the IRA. So when you think about the conversion, conversion can either be tax inclusive or tax exclusive. So when you think about the former, if you’re doing a conversion, you can essentially use the IRA dollars to pay the conversion income tax. That’s one option. If you do so, you’re reducing the balance of the IRA.

The other option would be to use nonretirement assets to pay the conversion tax. And, in fact, that’s probably the preferred way for many because it actually allows the full pretax value of the traditional IRA to be converted to the Roth IRA. So you’re basically increasing the after-tax value of the Roth IRA by doing that step—by paying the income taxes from nonretirement assets.

When you think about it from an income-tax standpoint, you want to think about how you’re using the Roth IRA. So, for instance, if you’re a retiree and you want to use those monies during your lifetime, then you want to think about what your current income tax looks like versus what it will be in the future in retirement when you’re taking distributions. And it’s the marginal income tax rate that really makes a difference.

Diane Streleckis: And when we’re thinking about your beneficiaries, what are some of the considerations that need to be taking into account?

Maria Bruno: Many people are entering retirement with large tax-deferred balances that they’ve accumulated over their career, so they may be weighing this Roth conversion decision because maybe they want to earmark some assets to their heirs.

Today in 2016, the combined value of the federal and gift-tax exemption is $5,450,000. And that’s above the annual $14,000 gift-tax exclusion amount that one can give during their lifetime.

Diane Streleckis: And what about gifting with a Roth, does that make sense?

Maria Bruno: If you make the decision to do annual gifting, if the donee actually has earned income, you can make the contribution for the donee. So, for instance, if you want to give annual contributions to your children, as long as they have earned income, you can make the contribution to his or her Roth IRA. And the cap is $5,500 for 2016, assuming that the donee’s under age 50. But that’s one way to gift assets while using the annual gift-tax exclusion.

Diane Streleckis: So, Maria, you talked a little bit about some of the income tax implications. Can you explain that a little bit more for us?

Maria Bruno: So when you think about Roth conversions, especially as a wealth-transfer tool, it’s really important to think about the income tax picture both for you but also for your beneficiaries. So a common rule of thumb, for instance, for conversions for someone who is spending the account during their retirement, for instance, would be to think about what your current income tax rate looks like versus what it will be later in retirement when you’re making withdrawals.

So a common guideline is if you anticipate being in a higher tax bracket, then a Roth conversion—again paying the income taxes on the conversion today at a presumably lower income tax rate—would be beneficial. And that way the account can then grow tax free. You’re not subject to required minimum distributions during your lifetime. So that’s a rule of thumb for someone who’s using the account during his or her retirement.

But if you’re thinking about this from an estate-planning standpoint or as a way to transfer wealth, you need to think about what the future income tax rate picture will be for your beneficiaries. So you’re weighing your marginal income tax rate picture today against what it will be for your beneficiaries down the road when they will be taking withdrawals. And that can cloud the situation a bit.

So generally speaking, if you think your beneficiaries will be in a similar tax bracket or a higher marginal tax bracket, then a conversion may be advantageous. Because you’re paying the income taxes today, you don’t have to take distributions throughout your lifetime and then your beneficiaries, while they’ll have to take distributions, they won’t be subject to federal income taxes.

The other thing to think about would be from an estate tax standpoint. And really, today, given how large the federal and gift tax exemption is in 2016—it’s $5,450,000. When you think about it, very few people are actually subject to the estate tax. So it really becomes more of an income tax discussion when you think about it in terms of the estate-planning conversation.

However, if you are subject to the federal estate tax, when you think about what assets to pass to your beneficiaries, when you do a Roth conversion, you are actually passing an asset. You’re removing the embedded tax liability.

But then, also, if you are subject to the estate tax, the estate tax is tax inclusive; so if you’re doing conversion, the dollars that are used to pay the conversion are removed from the estate and then any potential growth of those dollars as well.

Diane Streleckis: Some people designate charities as their beneficiaries. Does using a Roth for wealth transfer make sense in that instance?

Maria Bruno: If you’re charitably inclined, you really want to think about this in the context of the entire financial plan. And as advisors, as you’re working with your clients, you really want to think about what does the entire picture look like in terms of the different account types, what the goals for the accounts are, and then who the beneficiaries are. So thinking about it from that standpoint can then make the decision in terms of, all right, what are the best types of beneficiaries for the different account types?

And, Diane, since I mentioned the annual gift tax exclusion, I just wanted to spend a minute on that, because I think sometimes we tend to discount what the benefit of that can be. But if you think about it, particularly from a Roth strategy standpoint, it can be actually a very interesting strategy. So if you think about lifetime gifting, one way to do that certainly would be gifting outright or potentially even gifting highly appreciated assets to beneficiaries who might be in a lower tax bracket. That could be one viable strategy.

So if you are charitably inclined, then it may not make sense to do a Roth conversion and pay income taxes today or it may be better not to have the charity as the beneficiary of the Roth assets. And the reason is the charity can get the full value of the IRA and not be subject to federal income taxes when they take distributions.

Diane Streleckis: What additional tips do you have for financial advisors looking to employ this strategy?

Maria Bruno: I think making the Roth conversion discussion part of the annual checkup is a very viable strategy. Using this Roth conversation as part of an annual financial planning process is very beneficial for a couple reasons.

One, advisors can really work with their clients in making the decision whether or not to convert assets. I think looking at the entire financial plan—what the assets are, what the resources are, what the goals are, who the beneficiaries are—an advisor can work with a client and tie all this together and really give guidance in terms of whether or not to do a conversion and how much overall. Then the advisor can actually work with the client to figure out, okay, well how best to do this while managing the conversion income tax liability.

So Roth conversions do not have to be all or nothing. And, in fact, series of partial conversions are probably the best bet for many individuals. So an advisor can work with their clients to understand once the conversion decision has been made, then to decide how much to convert on an annual basis but also think about what that annual tax picture looks like, because there may be strategies to employ to help minimize what that conversion income tax liability could be.

So, for instance, using charitable contributions to offset that conversion income tax is one strategy to help minimize the income tax liability. The other would be AMT. So if you’re subject to AMT, an advisor can actually work through those numbers to see whether conversion could be beneficial from an AMT standpoint.

So there’s a couple strategies there on a year-by-year basis that an advisor can work with you to make sure that you meet your current and long-term goals but do so in a very tax smart way.

Diane Streleckis: Those are great tips, Maria. And thanks so much for being with us today. We really appreciate your time and your insights.

Maria Bruno: Thanks, Diane, good to be here.

Diane Streleckis: And thank you for joining us for this Vanguard Investment Commentary Podcast. Be sure to check back with us each month for more insights into the markets and investing. And, remember, you can always follow us on Twitter. Thanks for listening.

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