Estate Planning Opportunity: Conversion of Traditional IRA or 401(k) Accounts to Roth Accounts

This may be a good time to rollover a traditional IRA or 401(k) account into a Roth IRA or a designated Roth account within a 401(k) plan. Federal and state income tax rates are probably as low as they are likely to get, most of the value of tax deferral depends on lower tax rates in the future, and accounts that include investments in equities have most likely substantially dropped in value as a result of the COVID-19 pandemic. 

Both traditional and Roth accounts allow income and gains to grow tax free until distribution. For rollover purposes, the difference between them is how and when distributions are taxed. While traditional IRA accounts are taxed at ordinary income tax rates when distributed and are funded with pre-tax dollars, rollovers to Roth accounts are taxed at ordinary income tax rates on contribution and there is generally no tax on distribution. Rollover distributions from traditional accounts to Roth accounts are treated as taxable distributions in the year of the rollover, but there is no early withdrawal penalty for the rollover if you haven’t attained age 59 ½.

For many of us the consequences of the pandemic have included a reduction in earned income. If reduced income puts you in a lower tax bracket, that would lower the cost of a rollover. It might further help to lower the tax costs of a rollover if you are able to stagger the distributions over multiple tax years to keep your marginal income tax rate lower, and with the 2019 tax year filing delayed you may be able to do two rollovers during 2020 that would be treated as occurring in different tax years. Consult with your tax advisor to determine if this makes sense for you.

The pandemic has reduced portfolio values. So, any rollover done now has less associated income tax than a rollover of the same percentage of the account when it had a higher value.

In determining the benefit of a rollover to you and your beneficiaries, you should weigh whether you expect the future income tax rate on distributions from a traditional account to be higher, the same, or lower than the total tax rate you would pay today if you do the rollover, including the effective rate of any capital gains on the sale of assets to pay the tax. If you expect the rate to be the same or higher, the income tax deferral of the traditional account is less likely to be of value to you and that would favor a rollover to a Roth account. 

For estate planning purposes, a rollover from a traditional account to a Roth account has several additional potential benefits that may be useful, whether or not an income tax deferral analysis would otherwise warrant the rollover. First, if you plan to leave the bulk of the account to your children, paying the taxes with your current liquid assets is like making a gift of the tax payment to them without triggering any gift or estate tax liability. Any taxes you pay now will not have to be paid by your children when they receive distributions from your retirement accounts.

Second, the current payment of the income tax reduces the value of your estate for estate tax purposes. While reducing your estate doesn’t sound like a benefit to you while you are living, it is actually not a reduction at all because traditional account values are burdened by the taxes you must pay to access them.

Third, if IRAs and 401(k) plans constitute a substantial part of your net worth and you will be subject to state or federal estate taxes, a Roth account can be used on a dollar for dollar basis to fund a “credit shelter” trust that passes estate tax free at your spouse’s death, whereas the income taxes payable on a traditional account reduce the amount sheltered.

Finally, if you don’t expect to need most of the funds in your Roth 401(k) account during your life, you should roll it over into a Roth IRA before you reach the age when you must take minimum distributions from the account because, unlike a Roth 401(k) account, your Roth IRA is not subject to required minimum distributions during your life and can build up value tax free.