How to Use a Roth Conversion to Protect Your Heirs From a Big Tax Bill

Taxes. You can't avoid them. But you can minimize them or even postpone them. And if your goal is to leave a sizable IRA to a beneficiary -- say a spouse, or children -- without saddling them with a big tax bill, there are also measures you can take. One of them is converting any eligible retirement accounts to a Roth IRA.

But first things first.

Taxation of ordinary inherited IRAs

The SECURE Act of 2019 changed many of the rules regarding how a recipient of an inherited IRA is taxed, while new rules issued in 2022 tweaked these rules just a bit further. Some of them can be a little bit complicated (particularly when they're left to minor children or disabled individuals).

Most of the rules that will apply to an IRA account owner who passes away in or after 2020, however, are easy enough to understand.

Take the rules for anyone inheriting a spouse's ordinary retirement account, for example. One option is a simple tax-free rollover of the deceased's IRA or 401(k) assets into the surviving spouse's own IRA, where it's then treated -- for tax purposes -- as if it were always the beneficiary's.

That's not the only option, though. At the other end of the spectrum, the recipient of a deceased spouse's ordinary IRA can take it as a lump-sum payout. There's no penalty for doing so, regardless of age, either, although the entirety of any payment choice is taxed as income at the time it's made. As such, this choice can quickly get expensive.

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There are some in-between options, too. For instance, you could transfer these assets to an inherited IRA. This choice allows the spousal beneficiary to empty the account within the following 10 years, including taking it as a lump sum at any point during that time, or, where applicable, continue any required minimum distributions -- or RMDs -- that had already begun (although at recalculated RMD amounts based on the recipient's life expectancy).

Whatever the case, each of these choices still results in a tax bill on the amounts received in the year they're withdrawn.

Things can get a bit more complicated with a regular retirement account left to anyone other than a spouse, including a child or children. In these instances, the assets in question can't be transferred to their own IRA and then treated/taxed as their own retirement savings when that time comes.

Rather, in most of these cases, the recipient must empty out the retirement account in question within 10 years, although in a handful of cases -- like minor children, or recipients not more than 10 years younger than the deceased -- the beneficiary is able to take distributions based on their own life expectancy. Or in a case where the original owner had already reached the required minimum distribution age, the new non-spouse owner must continue taking these payments based on their own life expectancy in addition to following the 10-year rule, or take a lump-sum payment of the entire account value.

Regardless, although there's no additional age-based penalty for withdrawals taken before the beneficiary is of retirement age, all of these distributions are considered a taxable withdrawal. Obviously, you'll want to speak with a qualified professional familiar with your particular situation to determine what works best for you.

Or, there's a much simpler alternative.

Converting to a Roth IRA solves a lot of these problems

It won't necessarily be the best choice for everybody. However, converting your traditional IRA or 401(k) to a Roth certainly sidesteps many of the aforementioned headaches in handling an inherited IRA.

In contrast with a traditional IRA, which is funded with pretax income and taxed as withdrawals are made, Roth IRAs don't offer a tax deduction when money is put into them, but withdrawals are tax-free. Since they don't generate any tax revenue after they're funded, the IRS is far more flexible in how Roth accounts are left to spouses or children.

There are still some basic rules to consider, however. For instance, as would be the case were the original account owner still alive, a deceased's Roth account must still be established and funded for at least five years before a spousal beneficiary can be assured of making tax-free withdrawals from them. Otherwise, these withdrawals could be partially subject to income taxation. Surviving spouses can still roll over an inherited Roth into an account of their own.

Non-spousal recipients of an inherited Roth IRA don't enjoy the same flexibility. Although distributions from them are still tax-free, they still typically have to follow the 10-year rule, unless the same exceptions as with traditional IRAs apply. A tax-free lump-sum payment is also an option.

Here's the catch: All the taxes that you're hoping to help your family avoid? You're not avoiding them. You're simply accelerating them to a time when you're still alive, and -- maybe -- in a lower tax bracket than your heirs. See, Roth conversions are taxable events in and of themselves. In fact, since it is taxed as income, a big enough conversion can push you into a higher income tax bracket. That's why it may pay to do such a conversion in stages.

Nevertheless, you can control the timing of your Roth conversions, strategically completing them while the market's temporarily down, thus minimizing your tax liability resulting from the maneuver.

In this vein, you aren't required to cover your resulting tax bill from a conversion to a Roth using money from the IRA being converted. If you've got cash available outside the retirement account in question, using that money to pay this tax lets you keep more money in a tax-deferring vehicle, where it can continue growing tax-free.

Sounds great! So, how does one make it happen? Simply by converting an ordinary IRA to a Roth IRA. Your brokerage firm or retirement account's custodian should be able to help you do it.

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