3 Ways a Roth IRA Conversion Can Help Your Heirs

For those whose estates are large enough to face estate taxes—that is, greater than $12.92 million ($25.84 million for couples) in 2023—it makes sense to do as much as you can now to lessen the tax hit your estate might face later. 

To this end, one common tax-smart strategy is a Roth IRA conversion, in which you move some or all of your money from a tax-deferred retirement account into a Roth IRA. This move requires you to pay income taxes on any pretax funds in the year of the conversion, but doing so has two main benefits for your heirs: 

1. They won't owe any income tax on withdrawals from the account (assuming the Roth account is at least five years old—if it's less than five years old, only the earnings would be taxed). By comparison, distributions from an inherited traditional IRA are taxable.
2. If they don't need the money right away, they can leave it in the Roth account to potentially grow tax-free. Depending on the type of beneficiary they are, the money could continue to grow tax free for five or 10 years—longer if they qualify for a stretch IRA.

Plus, performing a Roth IRA conversion has the advantage of helping to immediately lower the value of your estate by the amount of conversion income taxes paid—ultimately reducing potential estate taxes for your family. 

Could a Roth IRA conversion be right for you? Here are three scenarios in which a conversion strategy could help benefit your legacy planning. 

If your estate's value is closing in on or already exceeds the current estate tax exemption, a Roth conversion may make sense. Also keep in mind that the exemption is scheduled to significantly decrease to an estimated $7 million per person in 2026. So even if you're under the threshold now, you might not be for much longer. 

Although you'll pay income taxes on any converted assets, the up-front income tax hit will reduce the size of your estate that could be subject to the 40% federal estate tax (if your estate is over the exemption amount). By comparison, the highest income tax bracket is 37% for 2023. While three percentage points doesn't seem like much, the savings could be significant for your high-net-worth beneficiaries. 

Take the example of a single father with assets valued at $21 million, including $8 million in a traditional IRA. If he converts his entire IRA to a Roth, at the 37% rate he would owe $2.96 million in income taxes. In turn, his estate would be reduced to $18.04 million—potentially leaving his daughter an additional $1.18 million in estate taxes avoided. 

¹_{Federal estate taxes max out at 40% for taxable amounts greater than $1 million. This hypothetical example is only for illustrative purposes.}

And since he already paid income taxes on those assets, any distributions his daughter takes from the Roth account will generally be tax-free—whereas she'd owe income taxes on withdrawals from an inherited traditional IRA. 

Even if your assets fall below the lifetime gift and estate tax threshold, if you have retirement funds that you won't need, you may want to consider a Roth IRA conversion to help maximize the tax efficiency of the assets your heirs inherit. 

All non-spousal heirs are subject to RMDs on retirement account assets they inherit, which means they must take distributions from the inherited accounts whether they want to or not. If they inherit a tax-deferred retirement account, like a traditional IRA, those RMDs will add to their taxable income. But if they inherit a Roth account, their RMDs will be tax-free, as long as the account was open for at least five years. 

Consider a different scenario involving the father and daughter above. Let's say the father is in the 28% tax bracket and lives in a state with no income tax. His daughter is in the 37% income tax bracket and lives in a high-tax state with a rate of 12%. If the father converts the IRA assets to a Roth, he pays the 28% income tax rate. If he doesn't convert the IRA, upon inheritance his daughter will be required to take RMDs in years 1-9 and the remaining assets in year 10—all taxed at a combined federal and state rate of 49%. The difference in overall income taxes paid is significant, making the case to at least consider a Roth conversion.

For business owners who placed a share of their business interests into a traditional IRA account early on and anticipate significant future appreciation, taking the tax hit now through a Roth IRA conversion could add great value to your family's after-tax wealth. 

For example, say you founded a startup and placed 250,000 shares of the company stock, which at the time was valued at $0.01, in your traditional IRA. Today, each share is worth $5, but has the potential to climb much further. If each share is worth, say $25 when you pass, your heirs will inherit a traditional IRA worth $6.25 million. Their RMDs could trigger a significant tax bill each year. If you were to convert the traditional IRA to a Roth IRA today, when it's worth $1.25 million (250,000 x $5), you would pay just $462,500 on the conversion—far lower than the total taxes your heirs would owe on the future value of the traditional IRA. And your heirs won't owe any taxes on the appreciation—effectively transferring $5 million ($6.25 million – $1.25 million) free and clear. 

There's nothing in the rules that says you need to convert all your traditional IRA assets to a Roth in one fell swoop. You can always convert funds at a later date, or even set up a recurring conversion schedule to spread out your income tax liabilities over time. For example, you might be better off waiting if you expect your income-tax rate to fall in future years, or you might convert just enough to keep additional distributions from being taxed at the next highest tax bracket. Keep in mind that when you do a Roth conversion, you increase your income and it can affect other areas of your financial situation, such as itemized deductions and income-related monthly adjusted amount (IRMAA).