Archives for December 2024

Administrative note: there will be no article next week (12/23), as I’ll be taking time off for the holidays.

Last week I linked to my “Roth Conversions Deep Dive” presentation from the recent Bogleheads Conference. And many people wrote in to ask about things that were not included in the presentation.

One of the biggest challenges in preparing for a presentation like that is the time limit. In this case it was a 50 minute session, but I was targeting 40 minutes of actual presentation time in order to leave time for audience Q&A. 40 minutes discussing Roth conversions may seem like a lot, but truly, this is a topic where it would be easy to have a three-day continuing professional education seminar for CPAs or CFPs, without running out of things to talk about. There are so many moving parts and so many different ways to look at the question.

Today’s article is meant as a follow-up, to answer a few of the things that people asked about most often in reply to the presentation.

If you haven’t watched the presentation yet, please do, as it provides necessary context for some of the discussion below:

Roth Conversion Deep Dive, with Mike Piper

One other point, by the way, is that the Bogle Center has opted to turn off comments on the YouTube channel so that we don’t have to moderate all the spam that unfortunately comes with financial topics. If you want to discuss any of the videos from the conference, I’m confident you’ll get plenty of discussion if you start a thread on the Bogleheads forum.

Creditor Protection

The details vary by state, but IRAs have some degree of creditor protection, whereas taxable accounts generally do not. So, whenever you’re using taxable account dollars to pay the tax on a conversion (i.e., to “buy more” Roth space), another thing that’s happening is that you’re also likely “buying more” creditor-protected space. But again, the details vary by state. If creditor protection is a major concern for you, consulting an attorney is a good idea.

Estate Taxes: a Point in Favor of Conversions?

With respect to the federal estate tax, it’s not, in theory, a point in favor of conversions, due to the income in respect of a decedent (IRD) deduction. In this context, the IRD deduction essentially says that the beneficiary who inherits a tax-deferred account will receive an income tax deduction for any additional estate tax that was caused by the tax-deferred account.

Example: You have a $1,000,000 traditional IRA and enough other assets that the full IRA is subject to the maximum 40% estate tax. And let’s assume that both you and your beneficiary have a 37% marginal tax rate (i.e., trying to eliminate that as a variable here, in favor of or against the conversion).

If you don’t do a conversion, the $1,000,000 IRA is subject to estate tax. At the 40% rate, that’s $400,000 of estate taxes. The entire $1,000,000 IRA is subject to income tax, but the beneficiary receives a deduction (IRD deduction) for the $400,000 of estate taxes paid. So it’s a net $600,000 of taxable income. At a 37% marginal rate, that’s $222,000 of income tax. So, after estate tax ($400,000) and income tax ($222,000) we have the beneficiary actually inheriting $378,000, net.

Now let’s assume instead that you do convert the whole amount. $1,000,000 conversion, at a 37% rate, leaves us with $630,000 in a Roth account. That $630,000 Roth account is subject to the 40% estate tax ($252,000). And that leaves us with $378,000 that the beneficiary receives. Key point being: same amount as in the scenario above.

However, there are three caveats here:

1. Minor caveat: the IRD deduction is an itemized deduction, so some portion of it may be “wasted” in overcoming the standard deduction for the year. But with the dollar amounts we’re talking about in the case of an estate that exceeds the exclusion amount, that’s not really a big deal.
2. Big caveat: many beneficiaries probably don’t know about the IRD deduction at all. I wouldn’t be surprised to see cases in which that available deduction simply does not get claimed, in which case the conversion (in our example above) would have been very preferable.
3. Big caveat which might not be relevant: with respect to state estate taxes (as opposed to federal), there’s no IRD deduction. So in cases in which we expect a state estate tax to apply, that is a significant point in favor of conversions.

Inherited IRA Rules

One thing I noted repeatedly in the presentation is that money in a Roth IRA can stay in the account for the rest of your life, plus up to 10 years (i.e., before your beneficiaries have to take the money out of the account). For married couples, the length of time in question is really “the rest of the longer of your two lives, plus up to 10 years” (because the surviving spouse can simply roll an inherited Roth IRA into their own Roth IRA and RMDs won’t begin until after that second spouse’s death).

And in some cases it could plausibly be longer than that, if, for example, you’re leaving your IRA to somebody who is disabled. The rules for inherited IRAs are extremely complex (this article — especially the flowcharts — is an excellent reference).

Marginal Tax Rate ≠ Tax Bracket

The other thing people asked about most often was the category of things that cause your marginal tax rate to be different than your tax bracket. There’s simply no way to cover all of them, because there are too many. I picked three that are very commonly applicable in retirement scenarios (premium tax credit phaseout, Medicare IRMAA, and the unique way Social Security benefits are taxed). But there are so, so, many more things that cause this type of effect. There’s the net investment income tax, medicare surtax, and really anything at all in our tax code that becomes applicable at a specific income level. And that’s a lot of things.

Any of these various provisions in our tax law can potentially be a relevant factor in a conversion analysis. That’s why I always encourage people to use actual tax software rather than DIY calculations.