The Mom Roth: Intergenerational Roth Conversion After The SECURE Act

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 will radically change how we view traditional and Roth IRAs. The most significant and expensive change is the elimination of the ‘stretch’ provision. Under prior law, we could take distribution on an inherited IRA over our life expectancy; this allowed us to take smaller distributions and continue the tax deferral (or in the case of a Roth IRA, tax-free accumulation) over our life expectancy.

The stretch is no longer. The SECURE Act requires that most inherited IRAs be distributed completely within ten years. This new rule applies to non-spouse beneficiaries. You can still stretch for minor children (until they reach the age of majority), disabled or chronically-ill beneficiaries, and beneficiaries within ten years of age of the IRA or qualified plan owner. The provision will cost taxpayers at least $15 billion over ten years, says the Joint Committee on Taxation. The provision applies not only to IRAs, but to most types of qualified plans, like 401(k), 403(b), 457(b), ESOPs, Cash Balance Plans, and even lump-sums from defined benefit plans.

Roths look better than ever. Given that IRAs will now have to be distributed within ten years, generally, the beneficiary will pay taxes at a higher rate. Even spreading the distribution equally over those ten years will result in much higher taxes in most cases. Consider the example of a 25-year-old granddaughter receiving a $1 million IRA from her grandmother, the additional tax created by the accelerated distribution amounted to around $400,000. Roth IRAs are subject to the 10-year rule, but Roths are distributed tax-free. The 10-year rule allows beneficiaries of Roth IRAs to continue the tax-free growth for 10-years. This growth opportunity now opens some analysis of inter-generational Roth strategies, including what I call the ‘Mom Roth.’

Mom Roth. The best way to illustrate the Mom Roth is what I did for my own mother. My mother was a depression-era baby (born in 1921). She was thrifty and a good saver, even though my Dad was a machinist and my Mom a bartender. Dad built up a modest 401(k) and left it to my mom when he passed. When she was 70 ½, she started taking Required Minimum Distributions, which irked her. I prepared her taxes and noticed she had ample room in her low tax bracket for additional income. Mom’s tax rate was well below that of my sister or me. We converted enough to ‘bracket-top’ her to the top of her bracket. If you look at the brackets below, you can see the bracket breakpoints:

Thus, a 65-year old would have $13,500 of standard deduction (0% bracket), plus $9,700 of 10% bracket and an additional $29,774 at 12%. A single, older person could have $52,975 of income and pay only $4,543 in taxes. Converting to Roth at those rates can be very beneficial. We used other funds to pay the taxes on the conversion.  

No Roth RMD. Another great feature of the Roth is the absence of an RMD. A person can live to an extended age, like my mom, who lived to 96 ½. Had she kept her regular IRA, she would have had a 12.3% RMD withdrawal. Instead, she let her Roth IRA build up and passed it on to my sister and me, tax-free.

Itemized deductions. Note that some seniors have a significant itemized deduction in the form of medical expenses, particularly in the case of long-term-care facilities. There was a client whose mother lived in a nursing home; he was able to convert over $80,000 a year in the lower brackets. Some older retirees are in a zero-tax bracket. Zero tax is a great tax rate for inter-generational tax planning.

Watch the floors. Some tax items have ‘floors’ or amounts which change the taxability or eligibility for the item. Two important floors to consider when looking at converting an older person’s IRA to Roth are the social security floor and the Medicare B&D IRMAA floors. My mom was getting Social Security and a very modest pension from GM. We carefully engineered her conversion to get the lowest possible tax rate, without driving her Social Security to full taxability. 

Inter-generational Roth planning can be a very effective tool. Going forward, IRA owners should carefully look at their heirs’ tax rates. Doing partial Roth conversions at the older generation’s lower bracket can provide an excellent opportunity to save for the next generation. A grandparent could make modest conversions and leave Roths to their grandchildren, who could then continue the tax-free accumulations for ten years and then continue investing on their own. Maybe that’s the best thing to get the kids or grand-kids for their birthday, a Roth conversion.