In some scenarios, the strategy can actually reduce the after-tax amount ultimately available to the client and family. The clients are accelerating the income tax payable during their lifetimes, at a significantly higher income tax rate, and not taking advantage of the new law’s full 10-year income tax deferral after they die. If the account owner has not retired, the negatives associated with accelerating taxable IRA withdrawals could be compounded by this strategy.
Before doing any significant Roth conversion in order to minimize income taxes to the designated beneficiaries, the planner must be mindful of the various potential negative aspects of the Roth conversion:
a. There is likely going to be a significantly higher income tax rate payable by the owner under a Roth conversion than there would be by taking minimum required minimum distributions during the owner’s lifetime. There is also the time value of the taxes saved by not converting.
b. The taxable growth in the after-tax RMDs can be controlled, and in any event the growth will receive a stepped-up income tax basis at the death of the account owner. This eliminates all income taxes on this growth up until the time of the account owner’s death.
c. Only 10 years of tax-free Roth deferral after the account owner’s death are permitted under the new law. This undermines the post-death tax benefits available to Roth IRAs under the old law.
d. The IRA owner may need to use the IRA funds themselves to pay the conversion tax, and therefore be converting much less than the entirety of the IRA distribution.
Another early withdrawal option that may produce significant income tax saving benefits would be to apply an “amortization approach” to the withdrawals. Under this plan, beginning when the account owner is retired, the owner can determine his or her (or joint, if married) approximate life expectancy, and then take withdrawals over this period plus 10 years.
For example, if a married couple are both age 72 and retired and feel their joint life expectancy is approximately 15 years, they could withdraw from their account assuming there will be a 25-year amortization table and a 5% interest rate, and that the designated beneficiaries could make any annual withdrawals the couple did not take during their lifetime.
The only modification to this plan would be for the designated beneficiaries to defer withdrawing all or some of the balance until after they retire but within the 10-year window, if this step will lower their overall taxes.
The major difference between the amortization approach during the couple’s lifetime and a plan of just taking required minimum distributions is that the withdrawals will be slightly greater in the earlier years and slightly less in the later years, which in turn will hopefully create a smoothing out of taxable income at lower tax brackets. The goals of this plan are to reduce the income tax rate at which the withdrawals will be taxed to the couple each year by avoiding a large bunching of income during their working years or in the event they outlive their life expectancy, and to reduce the income tax rate designated beneficiaries will experience when they receive the payments during what are likely to be their peak earning years. During the account owner’s lifetime, the annual distributions that exceed his or her RMD amount can be rolled into a Roth IRA, if desired.
2. Paying all or part of the IRA portion of the estate to lower-income-tax-bracket beneficiaries. The theory here is that, if we have to live with the new tax law, we can at least minimize its effects by planning our estates in a tax-sensitive manner. Assume, for example, that a client has four children, two of them in high-income tax brackets and two who aren’t. Why not consider leaving the IRA portion of the client’s estate to the children in lower brackets, and the assets with a stepped-up basis to the others? Of course, a drafting adjustment should be made for the fact that the lower-tax-bracket children will be receiving taxable income, whereas the others won’t be.