When I share stories with accountants, it’s interesting to me how financial planners struggle with client follow-through of tasks and accountants don’t. Accountants have a few luxuries - government deadlines and immediate realized benefit from acting to name a few. Financial Planners often have to balance functional jobs with emotionally charged life events that occur in times of life transition. On top of that, planning often deals with no immediate benefit or urgency. Often the functional jobs with low visibility add the most value heading towards the retirement glidepath.
Here is a story of a client where acting will save his estate several thousand dollars. I apologize for the amount of detail, but the tax math is important.
I have a client couple. They are both 80, live in Florida, and have $2,000,000 in their IRAs and there are 4 siblings - three in Virginia, one in New York. Kids are in mid-40’s. All have incomes over $200,000, with two of them having incomes over $400,000.
The parents had a taxable income last year of $140,000.
Some Key Tax Thresholds for context. 22% tax Bracket goes to appx $178,000; 24% Bracket goes to about $340,000 (Married Filing Jointly). There is also a minefield of tax thresholds for Medicare and other things between 182,000 and 250,000. More details later. Here is what I am trying to anticipate and plan for.
Scenario 1: Parents die tomorrow in a car accident
4 siblings get $500,000. For illustrative purposes, let’s say that the math pointed to taken out evenly - $50,000 a year for 10 years. Let’s also assume no growth in the account over 10 years, so the tax estimates are likely understated. Note: Funds must be taken out within 10 years.
This $50,000 would be subject to the state income tax as well as the tax bracket that the kids were in.
NY Child: 6.85% + 35% = $20,925 in taxes per year x 10 years = $209,250
VA Child: 5.75% + 35% = $20,375 in taxes per year x 10 years = $203,750
VA Child: 5.75% + 32% = $18,875 = $188,750
VA Child: 5.75% + 24% = $14,875 = $148,750
$750,500 in Taxes on a $2,000,000 IRA. This situation could actually be worse if your kids have a disability. Their SSDI would result that for every $2 of inheritance, $1 of SSDI would become taxable (up to the SSDI limits). Inheriting $40,000 a year, could result in $60,000 of taxable income.
Scenario 2: One Parent lives to 90, One Parent lives to 95 (15 years) and they begin a series of micro Roth Conversions - $40,000 per year for 10 years.
This $40,000 per year would (1) avoid state income tax since they live in Florida, and (2) pay in a lower federal tax bracket by 2 to 13%. So this move would save 7.75% to 19.85% annually and grow tax free.
Scenario 2: $400,000 Roth Conversions pay $88,000 in taxes - 22%
Scenario 1: $400,000 unconverted would pay $150,100 in taxes by the kids from the inherited IRA = 37.53%, a 70.5% increase over Scenario 2.
Scenario 3: One client dies today. Surviving spouse dies in 15 years.
In this example, beginning in year 2, the spouse will file as single and have lower thresholds for the respective brackets.
$140,000 Married Filing Jointly equals close to $70,000 Married Filing Jointly, but the IRA Distribution would be at $100,000. When you add Social Security and other incidental income, the widow has a Taxable Income of $130,000. IRA remains the same, less favorable tax brackets, lower standard deduction.
In short, the widow pays $27,246 on taxable income of $130,000. While the couple paid $22,034 on $140,000 of taxable income. $5246 a year in additional taxes and a Roth IRA conversion strategy for beneficiaries is likely not as viable, given her new income bracket.
Scenario 3: $78,690 in additional taxes for surviving spouse. Remaining IRA distributed to kids that could sabotage their retirement planning. This could result in not qualifying for ACA Tax Credits ($12,000 per year until Medicare eligible) if you planned to retire early, IRMAA premiums, more of your social security taxable, and other tax adverse, income-triggered tripwires.
Not asking your parents to do a Roth Conversion is asking for a spontaneous, likely unfavorable, yet avoidable, tax reaction. Even if you pay the taxes for your parents, you are still ahead.
Given this information, it may be worth it to trigger those minefields and still make out ahead.
Landmine 1: IRMAA Surcharge up to MAGI (Modified Adjusted Gross Income) of $228,000 = $1929/year
Landmine 2: IRMAA Surcharge for MAGI $228K to $284K = $4853/year
Landmine 3: 3.8% Net Investment Income Tax on MAGI Income over $250,000
Landmine 4: 24% Tax Bracket for taxable income over $178,000
In any event, the tax savings alone could be the equivalent of paying for college for a grandchild. It wouldn’t be limited to gifting ceilings. It could serve as an emergency fund for any medical catastrophes. It can grow tax free.
Let’s also don’t forget how vulnerable this income could be to future legislation. There is a clause in the Build Back Better Bill will hit some ultra high IRA’s harder = an 8% surtax. You also want to be in a place where you can take advantage of any changes to itemized deductions which could change this whole equation if they change the limits on state tax deductions.
I share this because THIS is financial planning. Saving a client and their spouse and children thousands, if not tens of thousands of dollars a year is something we can control. How International Stocks do compared to the S&P500 isn’t. Borrowing your parents tax bracket is creative and typically favorable to clients and their parents alike. Seems that giving the government less is bi-partisan and transcends generations.
So rather than asking your financial team if you should do a Roth Conversion, ask them if your parents should.
Drop me a note if you found this article useful. Your situation may differ materially, so please discuss this strategy with your financial professional.