Wade Pfau, Ph.D., CFA, RICP®

Maximizing the Combined After-Tax Value of IRAs and Roth IRAs

In the Spring 2015 issue of the Journal of Personal Finance, I was the co-editor with Joseph Tomlinson for this research journal sponsored by the IARFC. The issue has five articles, and the issue’s theme evolved rather organically into retirement taxation topics. The cover article by Professors Tom Potts and William Reichenstein is called, Which Assets to Leave to Heirs and Related Issues. This post is about that cover article.

But briefly, other articles in the issue include James Welch’s exploration of withdrawal sequencing between accounts with different tax status, Michael Kitces’ comprehensive overview of taxation issues related to deferred annuities, an article which demonstrates how when other confounding variables are properly controlled, there does not appear to be racial differences in financial behaviors, and an article which explores how financial professionals could better guide their clients by considering their health status and how that relates to important financial behaviors like conscientiousness and the ability to defer gratification to the future.

Which Assets to Leave to Heirs and Related Issues

Tom L. Potts, Ph.D., CFP®, Professor of Financial Planning, Baylor University
William Reichenstein, Ph.D., CFA, Powers Professor of Investment Management, Baylor University

The cover article explores whether it is better to leave a tax-deferred IRA or an after-tax Roth IRA as a bequest, in the context of recognizing that the retiree also needs to spend money from these accounts as part of their retirement income plan. The conventional wisdom is that a Roth IRA is the best option to include as part of a legacy, but that isn’t always the right answer.

The key insight to figuring out whether to bequeath an IRA or a Roth IRA is to recognize that someone, someday will have to pay taxes on the IRA. The idea is to have the person with the lowest marginal tax rate at the time those taxes come due to be the one to pay those taxes. Since the retiree’s time horizon is unknown, it is best to keep this in mind when making withdrawal decisions.

For instance, if the retiree is in a 40% combined tax bracket and the heir is in a 15% combined tax bracket, the retiree should be spending from the Roth account. The heir will receive a larger after-tax inheritance by being the one to pay the taxes on the IRA. Though this seems obvious with the explanation, it does counter the general conventional wisdom that you spend the IRA down first before spending the Roth IRA. Conventional wisdom would be right, though, if the tax brackets were reversed. The retiree should be paying taxes at 15% to avoid having the heir pay taxes on the funds at 40%. Thus, there is no general rule about which account the retiree should spend from, as it depends on the relative tax rates between the retiree and the heir.

The article provides many further interesting examples.

For instance, consider a case where a retiree is deciding about how to divide an inheritance including IRAs and Roth IRAs between two children, each of whom are in different tax brackets. To equalize and maximize the after-tax inheritance for both, more IRA should go to the child in the lower tax bracket, and more Roth IRA should go to the children in the higher tax bracket. As well, both children should understand that the pre-tax value of their inheritance will not be the same (and the author suggests having this conversation with them while alive, so that they don’t get too caught up on these less meaningful pre-tax values). The recipient of the IRA needs more to cover the tax
bill, in order to equalize spendable dollars after taxes.

The article then discusses the issue of Roth conversions. If taxes on the conversion will be paid from the IRA, then the matter again just involves paying taxes when the tax rate will be the lowest. If heirs will be in a higher tax bracket than the retiree, Roth conversions make sense. The issue can be a bit different if the tax bill on a Roth conversion will be paid with funds in a taxable account. Similar to the arguments made in my post about contributing to IRAs and Roth IRAs, Roth conversions can potentially make sense even if the heir is in a somewhat lower tax bracket, since it helps to avoid all those years of tax drag on the taxable assets. But in the article’s example, it takes 53 years of compounding before the Roth conversion makes sense when the tax rate will be lower in the future. The basic principle remains that one converts if it allows taxes to be paid at a lower rate than otherwise.

The article also talks about how to allow heirs to stretch IRA and Roth IRA distributions over their life expectancies, rather than being stuck with a 5-year stretch period (unless new government regulations change this). Individuals identified as designated beneficiaries (as opposed to beneficiaries) can do this. With the complexity of tax laws, it is important to consult with a trusted tax professional on this matter if it is not something you are already familiar with.

There are definitely a lot of potential tax savings involved with thinking strategically about the source of withdrawals in retirement, as the cover article of the newest issue of the Journal of Personal Finance has made clear.

Looking for individual financial help? Speak with an advisor from our sister firm, McLean Asset Management, today.

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