Roth Conversion at Death

Roth Conversion at Death

Case Scenario:

Sarah Roth (age 73) is a prospective new client. She is recently widowed. Her husband, Bill (who was 75), has $1,000,000 in his retirement accounts and she received $400,000 life insurance proceeds, tax-free. Sarah has chosen to move in with her daughter and grandchildren. She has sufficient income from Social Security, her own pension, and the proceeds from the sale of the house that she and Bill lived in before his death. 

Financial Goals:

• Sarah does not need any income from the retirement accounts or life insurance
• She wants to maximize the net after tax value from these two assets that will pass on to her

Possible Solutions:

A. Sarah keeps the retirement funds inside a spousal IRA rollover.

She has to take Required Minimum Distributions (RMD). Assuming that those funds grow at 6% inside the IRA, the $1,000,000 will grow to only $1,059,637 at her age 85 because of the RMDs. If she doesn’t need to spend the RMDs and lets the net after tax amount (assuming she is in a 30% income tax rate) accumulate at 4% net after tax, they grow to another $657,511 at her age 85.

Lastly, the life insurance proceeds also accumulate at 4% net after tax to $666,029 at 85. TOTAL = $2,383,177 at her age 85 (assumed mortality).

If Sarah dies at age 85, her beneficiaries will be required to withdraw all of the inherited IRA within 10-years after her death. Assuming that they let the funds accumulate and withdraw the total 10-years after her death, the $1,059,637 will have grown to $1,897,649. The $657,511 accumulated RMDs will grow to

$973,277 and the life insurance proceeds will have grown to $985,886.

TOTAL = $3,856,812

However, the $1,897,649 will be subject to income tax of $759,060 (assuming 40% income tax rate taken as a lump sum at the end of the 10-years).

The TOTAL net after taxes will be $3,097,753

B. Sarah could convert the $1,000,000 spousal IRA to a Roth IRA.

She could use the $400,000 life insurance proceeds to pay the income tax (assuming a 40% income tax rate because of the larger lump sum taxable event). The $1,000,000 grows to $2,132,928 at her age 85 (assumed mortality) because she has no RMDs.

The $2,132,928 continues to accumulate to $3,819,750 10-years after Sarah’s death. The beneficiaries withdraw that amount income tax free.

If all of the assumptions come true, that’s $721,997 net after tax more for Bill’s and Sarah’s beneficiaries if Sarah used the life insurance proceeds at Bill’s death to pay the income taxes on a Roth Conversion by Sarah (surviving spouse) at Bill’s death.

What if Bill died without a surviving spouse? Inherited IRAs cannot be converted to a Roth IRA.

Instead, Bill could have converted his own IRA to a Roth during his lifetime. If Bill converts to a Roth in the year before his death, the life insurance proceeds could still be used to fund the income taxes paid.

If he did not convert during his lifetime, then the life insurance proceeds reimburse his beneficiaries for the income taxes due when they have to withdraw the funds within 10- years after Bill’s death.

Any examples provided are hypothetical and for illustrative purposes only.  Examples include fictitious names and do not represent any particular person or entity.

The information provided is not written or intended as specific tax or legal advice. Baystate Financial, MassMutual, their subsidiaries, employees, and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.

Individuals involved in the retirement and/or estate planning process should work with a retirement and/or estate planning team, including their own personal legal or tax counsel. CRN202204-263840