2023 EP0527 | Financial Updates | Conversion as a Gift to Your Beneficiaries

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Peter, good to see you. Today I want to talk about a conversion as a gift to your beneficiaries. When considering which assets to leave your beneficiaries, there is one asset that is loaded with taxes IRAs. So inheriting an IRA is very different from inheriting a Roth IRA.

Explain the tax difference between taking distributions from a Roth versus a traditional IRA. Well, both are going to need to be liquidated within 10 years, and that is very different than what the rules were prior to 2020. In 2019, the SECURE Act was passed, which basically emphasized and confirmed the fact that your retirement accounts are for your retirement. They are not meant to be multigenerational wealth transfer tools. In fact, they can pass one generation to the next. But wherever you pass them, it must be liquidated within 10 years. Now, the tax implications are going to be different, right? If you pass a Roth on to beneficiaries, when they liquidate that account, it is going to be tax free income. However, with the IRA, when it passes to beneficiaries, that money still has never been taxed.

The government is not going to forget about that. So when they are required to make those liquidations, when they take that income, it is going to be 100% fully taxable as income. So that's the main difference, right, is that we understand there's kind of two buckets of retirement money.

There is tax deferred and then tax free. That quality is going to pass on to the next generation. But as they take those distributions, it's going to be a very impact on them. Very different impact on them.

Right. Now, I'm glad you brought up the SECURE Act because most non-spouse beneficiaries no longer can stretch those distributions over a lifetime. As you mentioned, they have to drain the account within 10 years, and that is leaving your beneficiaries with quite the tax burden. It is, yeah, because that income is going to be added on top of whatever income they are earning, and a lot of people receive inheritance during some of their peak earning years. And so when you take your own income and you add on this requirement to take a distribution from an inherited account, it can be a significant amount of income.

It can bump you up in tax rates and brackets. And a lot of people that I speak with, Aaron, express some concern for the estate tax. And most people, that's not going to impact them because estate tax levels are very high, at least for now.

That is subject to change and probably will change at some point in time. But most people are not going to experience estate tax levels. But before estate tax comes income tax. And if you pass a tax deferred account, an IRA, two beneficiaries, they are going to have to deal with that income tax. And by the way, if you have an IRA trust that was designed before 2019 and the SECURE Act, it may in fact do the exact opposite of what most IRA trusts were originally intended because it may make for 100% distribution to your beneficiary, 100% taxable distribution to your beneficiary because of this new change in how RMDs work. So yeah, there's a lot that goes into that SECURE Act that deals specifically with IRAs and generational wealth.

Make sure you update your plan. So converting your IRA to a Roth is really a great gift then to your beneficiaries. Converting your IRA to a Roth is a great gift to beneficiaries. It is essentially giving them tax free dollars. Now I do meet with some folks that say, hey, if I'm going to gift money to folks that didn't earn it, then I'm going to allow them to deal with the problem of taxation. And I get that.

I understand. However, those same individuals generally don't want to leave the IRS as their largest beneficiary. And a lot of times that's exactly what happens. Say that you've got an IRA that you are allowing three or four people to inherit. Well, the IRS may take the first 30 to 40% and then your beneficiaries are left to split the remaining amount as taxable income.

And so the IRS becomes your single largest beneficiary out of those that you intended, not what a lot of people really intend. Right. Good point.

So explain this as well. Distributions from an inherited Roth are both tax and penalty free. Right.

Yeah. Well, so when you inherit an account, if it's a Roth account, the taxes have already been paid on it. So it's going to be tax free. But with retirement accounts, right, we have if it's our own retirement account, the provision that we can't touch those dollars until fifty nine and a half. That's kind of the restriction that's put on it for the benefits that we get for qualifying it as a retirement account. But we didn't make that deal with the IRS when we inherited money.

And so that penalty is waived. If you've got a beneficiary that's younger than fifty nine and a half and they need or want or are required to liquidate the account within 10 years of receiving it. The government's not going to place that requirement on them and then penalize them for distributing it before fifty nine and a half. So a Roth inheritance is fantastic because it does already have the tax free quality and then it can be accessed without that additional penalty. By the way, inherited IRAs also can be accessed without the penalty. But because they haven't been taxed yet, they are going to be taxed when they're distributed. Right. But those inherited IRAs, they can never be converted.

No, they cannot. When you inherit an IRA, it is always in the name of the original owner, the person who actually earned and saved and set aside that money. You are the recipient of an inherited IRA or a beneficiary IRA. You cannot convert those dollars over to Roth. You've got to remove them from the retirement account protections and umbrella completely, pay the tax on it, and then you can reinvest the money into a non qualified investment account or find other ways to redeploy the money. If you don't need it to spend it to use it, but you cannot convert an inherited account from a traditional tax deferred to a Roth inherited account. And in case we want to give people one more nudge to consider a conversion, there is a five year holding period.

Explain that. Yeah, and this is important in case you may need to use those dollars. And ultimately, we saved dollars to use them for the most part. Now, if they're left behind, it's still going to be of benefit.

But if you need to use the dollars that you convert, there is a five year hold period when you convert from a traditional IRA to a Roth. And if you remove dollars within those first five years, there's a 10 percent penalty. And so we can avoid that by getting a jumpstart on things. And oh, by the way, it may be a good time to consider this now, because as tax laws stand, taxes are going to be going up into the future at the end of 2025.

So it may be cheaper to do it now and start sooner rather than later anyway. So somebody wants to talk to you a little bit more about legacy planning or how to set up their beneficiaries that they don't have this tax burden. What's the best way to reach you? Well, you can reach me at Rashan planning dot com online. You can hit a button and schedule time for a phone conversation or a consultation right there on the website. You can give me a call directly.

Nine one nine three hundred five eight eight six nine one nine three hundred five eight six. You can email me Peter at Rashan planning dot com. And I have to admit, Aaron, when I first read the story idea headline, I thought it was conversations as a gift to beneficiaries. And I thought that was a great idea in and of itself. We need to talk more openly about our money and finances, especially with the people who we intend to receive some of our finance and our money when we pass away. So those conversations are very important.

Have open conversations with your family, folks. I love that idea, Peter. We will do that next.

That's awesome. Too many people too closed off about their money. You're right.

No, you're right. And it's important. A lot of people are uncomfortable talking about money, but it is very important.

Good topic idea. All right. We got to thank you. We got to prepare the money for the people. We got to prepare the people for the money as well and transfer values as well as value. Yes. All right, Peter.

Thanks, Aaron. This has been Planning Matters Radio. The content of this radio show is provided for informational purposes only and is not a solicitation or recommendation of any investment strategy. You are encouraged to take investment tax or legal advice from an independent professional advisor. Any investment and or investment strategies mentioned involve risk, including the possible loss of principal advisory services offered through Brooke's own capital management. A registered investment adviser fiduciary duty extends solely to investment advisory advice and does not extend to other activities such as insurance or broker dealer services. Advisory clients are charged a quarterly fee for assets under management while insurance products pay a commission, which may result in a conflict of interest regarding compensation.