Affluent folks in Connecticut should consider doing a Roth Conversion. What is a Roth Conversion? This is when a distribution is made from an IRA, taxed and then converted into a Roth IRA. Here are Five Reasons the Affluent Should Do a Roth Conversion.
1) Reduce Your Taxable Estate
When you do a Roth Conversion income taxes will be due. For example, if you had $100,000 in an IRA that you wanted to convert, this would be taxable income in the year of the conversion. If your tax bracket was say, 30% the income tax due on this would be $30,000. Ideally you would have another source of cash to pay this tax. By paying this tax now you will reduce your taxable estate. Doing a conversion is counterintuitive. Almost every other facet of tax planning revolves around two simple ideas, accelerate tax deductions and defer income. The strategy is to defer taxes into the future. This approach has served taxpayers well over time. A taxpayer that does a conversion however is accelerating the income tax. Accelerating income taxes may not make sense to some people.
In 2019 the Federal Estate Tax Exclusion is $11.4 million per individual. This exclusion is indexed to inflation every year and increases modestly. If a married couple effectively uses the so-called portability feature they can double this amount to a $22.8 million exclusion. This should exclude a lot of taxpayers from paying a federal estate tax. However, for taxpayers with a taxable estate the tax rate is 40%. Ouch. Oh, and that is just the federal estate tax. The State of Connecticut has an estate tax where the rate that starts at 7.2% and tops out at 12%.
In addition to the Federal Estate Tax Exclusion there is an annual gift tax exclusion of $15,000. A taxpayer can give up to $14,000 per year to an unlimited amount of people and not have to file or pay a gift tax. Gifts over $15,000 to one individual would require the filing of a gift tax return. In addition to the annual gift tax exclusion there is an additional exclusion from the gift tax when paying for certain qualified educational and medical expenses. Qualifying expenses for higher education are payments made directly to the educational organization for tuition. Room and board, books and fees aren’t eligible for this additional exclusion. Qualifying medical expenses include allowable deductible medical expenses that aren’t reimbursed by insurance. The key to obtaining this additional exclusion is for the donor to pay the educational institution or the medical provider directly. Only payments that are paid from the donor directly to the provider will qualify for this additional exclusion. Checks payable to the children or grandchildren to reimburse them for these expenses won’t qualify. These gifts would not be eligible for this additional exclusion and would be subject to the gift tax rules accordingly. This exclusion allows people to reduce their estates beyond the annual exclusion without having to file gift tax returns or pay any gift tax. This is an effective estate planning strategy for people who want to help out their children, grandchildren or others and reduce their estate.
The other thing to keep in mind is that while you may not be subject to a federal estate tax due to the high exclusion, Connecticut residents may be subject to the Connecticut Estate Tax. In 2019 the State of Connecticut has an estate tax exclusion of only $3.6 million. This is significantly less than the federal estate tax exclusion of $11.4 million.
All taxpayers need to be careful about where they declare their residence is. It’s not uncommon for affluent families to have more than one home. Here is what needs to be addressed to establish residence in a particular state:
* Spend more than 180 days in that state
* Register to vote
* Register your vehicles
* Have your mail delivered there
* Have this address on your federal income tax return
* File any required state income tax returns
* Have your will and / or trust
* Have your doctors and medical services
* Have the majority of your credit card transactions
Caution needs to be exercised when declaring your residence. The states have become much more aggressive in attempting to collect tax dollars due to their ongoing budget deficits. Consult with an experienced estate planning attorney to address this issue.
Making federal and state of Connecticut estimated income tax payments may be required when doing a Roth Conversion as your income will likely be higher than the prior year. For taxpayers whose adjusted gross income exceeded $150,000 in the prior year can avoid an underpayment of tax penalty by paying in 110% of their prior year income tax. Federal estimated tax payments are made on Form 1040-ES. State of Connecticut estimated tax payments are made on Form CT-1040-ES.
2) Create Tax – Free Income
Doing a Roth Conversion is different than contributing to a Roth IRA. Eligible taxpayers can contribute up to $6,000 per year. Taxpayers age 50 and older can contribute an additional $1,000 in a so called ‘catch-up’ contribution. To be eligible for a Roth contribution a taxpayer needs to have earned income up to at least the amount of the Roth contribution. Earned income is from working as an employee or perhaps having self-employment income from your own business. The other condition is that higher income earners can’t contribute to a Roth IRA. For married couples filing a joint return their modified adjusted gross income must be below $193,000 in 2019. One advantage to a Roth IRA over an IRA is that taxpayers can continue to contribute to the Roth IRA over age 70 assuming they meet the two conditions mentioned earlier. Taxpayers are not allowed to contribute to an IRA after age 70.
If a Roth IRA meets two simple conditions then all of the distributions from the Roth IRA are income tax-free. The first condition is that Roth IRA account must be open for at least five years. The second condition is that the taxpayer be over age 59 1/2 when they start taking distributions. That’s it. Meet both of these two straight forward requirements and all of the distributions from the Roth IRA are tax-free. This is significantly different than an IRA. With an IRA you are allowed an income tax deduction for the contribution. Again, higher income taxpayers are not allowed to make a tax deductible IRA. They can still make an IRA contribution. It’s just that for the higher income taxpayers it would be non-deductible. The IRA then grows tax-deferred. Not tax-free, tax-deferred. The taxes on the IRA are deferred into the future. IRA’s are subject to the RMD rules discussed below.
Another awesome feature of the Roth IRA is that your contributions are considered to come out first. And these are always tax-free as there is no income tax deduction with the Roth IRA. Therefore, if you needed some cash whatever reason and you were under age 50 1/2 and / or the account wasn’t open for at least five years no problem. You can distribute up to your contributions without any income tax. Distributions over this amount (the growth or income earned on the Roth IRA) would be subject to ordinary income tax and a 10% income tax penalty.
There are additional exceptions to the premature withdrawal penalty. One exception is for a first time home purchase. You can withdraw up to $10,000 and not be subject to the penalty. This first time home purchase applies to the account holder of the Roth IRA and their children and grandchildren. An additional exception applies for college expenses. There is no penalty for distributions used for college expenses. This applies to the account holder of the Roth IRA, their spouse, children and grandchildren. As you can see the Roth IRA can be accessed by parents to help their children and grandchildren.
Another benefit to the Roth IRA is that it is not subject to the Required Minimum Distribution (“RMD”) rules that IRA’s are. These rules require taxpayers over age 70 1/2 to begin taking distributions from their IRA’s over their life expectancy. Failure to take that RMD results in a 50% penalty. That’s not a misprint. If you fail to take out your RMD you will owe a 50% penalty of the amount you failed to take out. That hurts.
The Roth IRA is not subject to the RMD rules during the owners and surviving spouse’s lifetime. A non-spousal beneficiary like a child or grandchild however is required to take the RMD. If the IRA meets the two requirements mentioned above however then the distributions are tax-free. You can see what an incredible wealth transfer tool the Roth IRA is. Having decades of tax-free growth over the parents and children’s lifetime is very significant.
It’s important to understand that a Roth Conversion doesn’t need to be a all or nothing decision. Taxpayers don’t have to decide to convert their entire IRA or not. Partial conversions are allowed. This means taking only a portion of the IRA and converting it. For example, if you had $500,000 in your IRA you might not want to convert the entire amount in one year. The income tax burden might be too much. After running tax projections it’s possible you would consider converting say $100,000 this year. You could always convert more of the IRA in future years.
3) Higher Tax Bracket in Retirement
If you believe you will be in a higher tax bracket in retirement you should consider a Roth Conversion. In 2019 the highest federal income tax bracket is 37% which starts for married couples filing a joint tax return with taxable income of $612,351. The highest State of Connecticut Income tax bracket of 6.99% is for married couples with adjusted gross income (“AGI”) over $500,000. Note the difference between AGI and taxable income is itemized deductions and personal exemptions. The most common itemized deductions are mortgage interest, taxes, medical and charitable donations. So if you had an IRA and you thought your tax bracket was going to be higher in retirement you would want to consider a Roth Conversion.
Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.