Traditional IRAs are an IOU to the IRS

By Elliot Raphaelson
Posted on September 14, 2023

“IRAs are now an awful, terrible asset to use for wealth transfer and estate planning.”

That was the message that IRA expert Ed Slott (IRAhelp.com) recently delivered at the Retirement Income Summit sponsored by InvestmentNews. He was referring to traditional IRAs.

It’s true mostly because all withdrawals from traditional IRAs are subject to ordinary income tax. [Ed. You don’t get the more favorable capital gains tax rate, no matter how long stocks were held in your IRAs.] Moreover, tax rates will likely increase in the future.

Recent regulation stipulated by the SECURE 2.0 Act is another factor. Because of that legislation, few beneficiaries other than surviving spouses can use the “stretch option” [that enables them to gradually withdraw the funds in the account over the beneficiary’s lifetime].

Almost all other beneficiaries are required to withdraw everything in an IRA by the end of the tenth year, starting the year after the original owner’s death.

RMDs add complexity, taxes

In addition, if the owner had already reached his/her required beginning date (RBD) for withdrawals, the beneficiary is also required to take required minimum distributions (RMDs) for years one through nine.

If the owner had not reached his/her RBD, the beneficiary is not required to take RMDs in those years, but he/she does have to withdraw all balances in the IRA by the end of the tenth year.

Slott points out that traditional IRAs are subject to RMDs after age 72 or 73 (after age 70½ for older owners). [These ages will continue to rise over the next decade.] As with other withdrawals, RMD withdrawals are taxable at ordinary income rates for IRA owners.

Furthermore, because RMD withdrawals are based on IRS expected life tables, owners are required to withdraw a larger percentage of their balance each year.

Many individuals in their 70s and older find that their marginal tax bracket is higher in retirement than it was in their working years. One of the reasons is that for many retirees, 85% of their Social Security benefits are taxable.

So, many people with pension income, income from other investments, Social Security benefits and RMDs find themselves with a higher marginal tax bracket in retirement than when they were working.

Why a Roth is better

Roth IRAs are much better for beneficiaries than traditional IRAs because withdrawals from these accounts are not subject to federal income taxes.

However, with the exception of surviving spouses and other eligible designated beneficiaries (EDBs), because of the provisions in the SECURE 2.0 Act, all Roth IRA balances also have to be withdrawn by the end of 10 years after the owner’s death.

After that point, income from balances will be taxable unless the funds are invested in municipal securities or other alternatives that have non-taxable income.

Conversion to a Roth IRA

Slott says a traditional IRA is an IOU to the IRS, so he believes in looking for alternatives.

One alternative is converting a regular IRA to a Roth IRA. The amount you convert will be subject to ordinary income taxes at that time. [But any additional gain in the value of investments in the account will be tax-free when withdrawn at least five years later.]

If you have not reached the age when RMDs are required, you can convert an unlimited amount of your traditional IRA to a Roth IRA. To avoid a higher income tax bracket in any given year, you can gradually convert your traditional IRA funds to a Roth IRA.

If you have already reached the age of mandatory RMDs, you must first take your required RMD, and above that amount, you can convert your traditional IRA balances to Roth IRAs.

Converting to a Roth will benefit both you and your beneficiaries. Withdrawals from the Roth and any increase in value and earnings will not be taxable after a Roth account has been established for five years and you reach age 59½ . Any of the amount you convert can be withdrawn at any time without penalty.

Life insurance option

Slott believes that buying life insurance is another attractive estate-planning option.

Life insurance proceeds will be income-tax free to your beneficiaries. They can also be estate-tax free if paid to an irrevocable life insurance trust.

An insurance trust is much more flexible than an IRA trust. You can establish the terms of the trust so that you can establish the schedule in which your beneficiaries would receive the life insurance proceeds.

With some insurance policies, such as whole life, there can be benefits to you as the owner of the policy as well. If there are cash values in the policy, you can have access to the value on a tax-free basis.

With other policies, you have the option to have long-term care riders added. These would be useful if you need healthcare during your life.

Naturally, you should consult a qualified life insurance professional if you are considering life insurance options for estate-planning purposes.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.