By Dr. James M. Dahle, WCI Founder
In our own personal financial lives, Katie and I are focusing a great deal on legacy and estate planning. Recently, I was spending a lot of time thinking about Roth conversions. In our situation, a Roth conversion would:
- Increase our asset protection,
- Facilitate estate planning,
- Decrease total income taxes due (since we're likely to spend the rest of our lives in the top tax bracket), and, most importantly,
- Decrease estate taxes due by reducing the size of the estate (since taxable money would be used to pay the tax bill of the conversion).
Our kids would obviously much prefer inheriting Roth assets that they could then stretch another 10 years before withdrawing the money. So, at first glance, it would seem obvious that we should convert all of our tax-deferred money to Roth money. However, since these Roth conversions would all take place in the top tax bracket (37% federal + 5% state = 42% now and perhaps higher later), there's a pretty serious cost to doing them. Nevertheless, I was just about ready to bite the bullet and start paying for Roth conversions. Then I realized something.
“We're eventually going to leave more money to charity than we have in our tax-deferred accounts.”
Rules of Thumb for Roth Conversions
This is a big deal with serious implications. There are a few rules of thumb that apply here. Consider these rules:
- You should spend down your taxable account before touching your retirement accounts, whether tax-deferred or tax-free.
- Roth accounts are best left to heirs since there are no taxes due and they can be stretched for 10 more years.
- Tax-deferred accounts are best left to charity since neither you nor the charity will pay taxes on any of that money.
- Required Minimum Distributions (RMDs) start at age 73 in 2023 (but will eventually begin at 75), and your entire RMD can be a Qualified Charitable Distribution (QCD) with no associated tax bill.
- Leave enough to your kids that they can do anything they want, but not nothing. Warren Buffett said that.
Then, I look at our numbers and our own estate planning and realize a few things:
- We're going to live the rest of our lives just fine solely off of our taxable account, assuming we ever stop working!
- We're going to leave more to charity than we will ever have in tax-deferred accounts.
- We will probably only leave a relatively small percentage of our wealth to our heirs.
In short, we are “wealthy, charitable people.” When you sum up those rules of thumb and look at your numbers, you may find you are in the same situation as us. And guess what? Roth conversions don't make sense for wealthy, charitable people. If you are also wealthy and charitable, you should be aware of this, unless your favorite charity is the US Treasury.
Running the Numbers
Let's use some hypothetical numbers for a wealthy, charitable couple. Let's define wealthy as “has enough money to have an estate tax problem.” That amount, at least as far as the federal estate tax exemption is concerned, is $25.84 million for a couple ($12.92 million single) [2023] and indexed to inflation. However, under current law, that exemption will be halved starting in 2026. Let's define charitable as “wanting to leave millions to charity.”
Say there is a couple with a net worth of $30 million who wants to leave $15 million to charity and $5 million to each of their kids. Now, let's say they have $7 million in tax-deferred accounts, $3 million in tax-free (Roth) accounts, and $20 million in a taxable account. What are their options?
If their goal was to leave as much money as possible to their kids, they would do a Roth conversion on all $7 million of tax-deferred money. That would cost something like $3 million in taxes. Now they would have an estate of just $27 million, and they would have to pay estate taxes on $27 million – $23.4 million = $3.6 million instead of $30 million – $23.4 million = $6.6 million. Using rough numbers, they've cut their estate tax bill from $2.64 million to $1.44 million, a savings of $1.2 million. Plus, the kids will have $10 million in Roth money instead of just $3 million, which would likely double tax-free if they stretch it the full 10 years. It's a total no-brainer, right?
But that's not what this couple wants to do. They want to leave half that money to charity. They're not going to have an estate tax bill at all, since the amount left to heirs is less than the exemption amount. And the charity doesn't care if it receives tax-deferred money, tax-free money, or taxable money. It's all the same to them; the charity will pay no income taxes on it.
What happens if that couple does the Roth conversion? Heirs get $5 million each—$3.33 million in Roth money and $1.67 million in taxable money (with a step up in basis at death). The charity gets $12 million.
What if they don't do the Roth conversion? Heirs get $5 million each—$1 million in Roth money and $4 million in taxable money (with a step up in basis at death). The charity gets $15 million.
By NOT doing the Roth conversion, the couple can leave $3 million more to their favorite charity instead of Uncle Sam. So, unless your favorite charity is the US government, NOT doing a Roth conversion seems like a no-brainer.
But the Heirs Want Roth Money!
There is one more issue, of course. The heirs would prefer to inherit Roth money instead of taxable money. Of course, there's no difference if they withdraw/spend the money immediately. It's all the same to inherit a taxable account with a step up in basis at death or a tax-free account. But if they're smart and they stretch out the Roth money another 10 years, there will be another 10 years of tax-free growth that they can also get as an inheritance. How much is that worth?
Let's assume the heirs invest very tax-efficiently and only lose 0.5% a year in tax drag and then lose 23.8% of gains after 10 years. How much less do they have if they inherit $2.33 million in taxable money instead of $2.33 million in Roth money?
Roth inheritance:
=FV(8%,10,0,-2333333) = $5.o4 million
Taxable inheritance
=(FV(7.5%,10,0,-2333333)-2333333)*(1-23.8%)+2333333 = $4.22 million
They get $5.04 million – $4.22 million = $818,000 less a piece. Multiplied by three kids, it's $2.45 million less they inherit after the 10-year stretch period. The charity got $3 million more (and 10 years earlier) at the cost of just $2.45 million less to the heirs. If you adjust that charitable donation for the time value of money using that same 8% figure,
=FV(8%,10,0,-3000000) = $6.48 million
then you essentially created $4 million of wealth ($6.48 million – $2.45 million) by NOT doing a Roth conversion.
This was quite a revelation to me. And it has caused me to start thinking about four more related issues.
Should We Keep Contributing to Tax-Deferred or Roth Accounts?
The first issue is what we should do with future contributions. In some of our accounts, this decision is very easy:
- Roth IRAs: We'll continue to contribute via the Backdoor Roth IRA process since a tax-deferred IRA is not an option
- WCI 401(k): We'll continue to do Mega Backdoor Roth contributions instead of tax-deferred employer contributions due to the 199A deduction
- Defined Benefit Plan: We'll continue to do tax-deferred contributions, as there is no Roth option
- Clinical practice 401(k): This one is the real dilemma. If we do Roth contributions (or even Mega Backdoor Roth contributions if they are ever allowed), then a larger percentage of what our kids get will be Roth money. If we do tax-deferred contributions, then we get a big tax break now and never pay taxes upon withdrawal, resulting in more left to charity. I suspect, it is smarter to do tax-deferred contributions here.
Should We Invest Those Retirement Accounts Differently?
Another issue that comes up is that if we know we aren't really investing these retirement accounts for our own retirement anymore, should we use a different asset allocation? We generally have a separate asset allocation for each of our financial goals. Our children's Roth IRAs, our children's 20s funds (UTMA accounts), and our children's 529s all have different, separate asset allocations from our retirement money. We have traditionally lumped our taxable, tax-deferred, and tax-free retirement accounts together into one asset allocation aimed at paying for our retirement. Perhaps now we should have a different, separate asset allocation for our tax-deferred accounts that we know will go to charity and a different, separate asset allocation for our tax-free accounts. Since we know we won't need this money ourselves, it would stand to reason that it could be invested more aggressively than our true retirement savings (which is in our taxable account). Definitely something to noodle on.
What About That Health Savings Account?
It gets even more complicated. Should we continue to contribute to our Health Savings Account (HSA), and should we spend that HSA money on ourselves, leave it to heirs, or leave it to charity? The longer it stays in the account, the more it benefits from tax-protected growth. But when it comes out of that account, unless it is spent on healthcare during our lifetime, it will be taxable. If it gets left to heirs, it is 100% taxable to them. But the internet doesn't seem to really know what happens if it gets left to charity. Some articles suggest it is taxable to the estate (although I assume it would be offset by a charitable deduction) while other articles suggest it can be left income tax-free (and presumably estate tax-free) to the charity. IRS Publication 969 is vague on the subject:
“Death of HSA Holder
You should choose a beneficiary when you set up your HSA. What happens to that HSA when you die depends on whom you designate as the beneficiary.
Spouse is the designated beneficiary.
If your spouse is the designated beneficiary of your HSA, it will be treated as your spouse’s HSA after your death.
Spouse isn’t the designated beneficiary.
If your spouse isn’t the designated beneficiary of your HSA:
- The account stops being an HSA, and
- The fair market value of the HSA becomes taxable to the beneficiary in the year in which you die.
If your estate is the beneficiary, the value is included on your final income tax return.”
I asked the Bogleheads to see if anyone really knew the answer. I'm still not sure anyone does! But the answer matters. If you can leave your HSA tax-free to a charity, maybe we should not worry so much about having it all spent by the time we keel over. Either way, we should not spend it on anything besides healthcare. No Stealth IRA for wealthy, charitable people. They should either spend it on healthcare or leave it to charity.
What About Charitable Trusts?
The other thing to consider when planning to split your estate between heirs and charity is whether you can pay even less in tax by using a charitable trust or two. We're talking about CRATs and CRUTS, CLATs and CLUTs here. With the remainder trusts (CRATs, CRUTs), your heirs get taxable payments over many years, and the charity gets what's left tax-free when they're dead. But the ongoing income is likely going to be taxed in much lower tax brackets than one big fat inheritance.
With the lead trusts (CLATs, CLUTs), the charity gets the payments, and your heirs get the lump sum at the end. This could potentially reduce both income and estate taxes, especially if you formed the CLAT or CLUT in the same year you sold a business or something.
Lots of complexity here, but definitely something worth discussing with the estate attorney and/or accountant.
The Bottom Line
Roth conversions are great tools for those trying to leave as much after-tax money as possible to kids and grandkids. But for the wealthy with serious charitable inclinations, doing a Roth conversion probably just means leaving less money to charity.
If you need extra help with planning for retirement or have
questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
Does this information make you less likely to do a Roth conversion? Have you rethought how much you want to leave to your heirs vs. how much you want to leave to charity? Why or why not? Comment below!
Hmm. Interesting article but I guess I’m stuck on a couple things. Might not affect your assertion but changes the calc I think for me and I’m not sure from the article how to think through it so if you could consider these two alternatives it would be great.
While I might see having a $30m issue, a lot of that would be in property/vc capital funds and so not liquid securities. Taxes required if sold and also thinking about how that could be allocated if not liquidated would be helpful.
Secondly in your example you are saying give $5m to heirs. Views clearly differ here but I’m not seeing that as living up to the Buffet ideal. $5m doesn’t seem like enough for an heir to do anything, but not nothing. I’m in CA – Bay Area though where a median house goes for a million now. I would want skip generational wealth established first before doing that level of charitable (Others would certainly differ in this view.) I can do this with a trust but how would you think through that affecting the model?
You can leave property to charity in your will and no taxes would be due. I suppose you could leave illiquid securities too. Not sure what that has to do with whether wealthy people should do Roth conversions though.
I could live on $5 million for the rest of my life so that seems dangerously close to “enough to do nothing.” Even if a kid bought the median Bay Area house, they’ve still got enough for a $160K income without doing a thing.
5M is financial independence for 90%+ of the world
Even that’s probably out of touch. 99%+ at least.
To carry the thought experiment further – if tax deferred accounts are headed for charitable giving, you can compare them head to head with DAFs and in many instances the DAF would win. The IRA/401k has unquestionable benefits, like perhaps an employer match or the ability to change your mind later and use the money yourself. But if you know for sure that the money is going to charity why bother with arcane 401k rules and contribution limits? just do the DAF instead. This would be even more true on the fringes, such as solo 401ks, adding profit sharing contributions that need to be shared with employees or adding expensive to administer defined balance cash benefit plans. The DAF clearly wins in these cases. The big question is how sure you are that the money is going to charity?!?
The problem with putting that money in a DAF is you put after tax money into a DAF, but pre-tax money into a 401(k). So you can give more to charity with a 401(k) than a DAF.
But since you can itemize the DAF doesn’t it come out the same? I guess minus the standard deduction you would have received regardless.
Fair point. So long as you get the entire charitable deduction for the contribution, it’s exactly the same I suppose.
I found this exercise to be helpful, but I would love if you gave a more modest example.
I share the underlying principles of both pursuing some legacy (though I favor more doing it while I’m alive, instead of when the kids are in their 60s) and charitable goals. But I don’t think I will ever reach the IRS limits.
I just did my first Roth conversions in 2022 and this week to take advantage of the down market. But maybe I shouldn’t have? Would any of your thoughts change if the total was $6-10 million, with half going to children and half to charity? Currently 80% of our assets are in pretax IRAs, the rest mostly in our home. Our taxable assets were depleted as we waited to be able to access the IRA.
We currently take IRA distributions for income. SS and a pension will eventually cover half of our expenses. We plan to give from our IRAs once we are 72 to reduce the RMDs as they look like they will double our income.
I had planned to take out additional distributions as Roth conversions and to fund a DAF, but maybe I shouldn’t?
In your case if you’re planning to leave half your assets to charity, I think it’s fine to do some Roth conversions, but I wouldn’t convert the whole thing. The idea here is that you don’t want to pay taxes to convert something that isn’t ever going to be taxed.
If you want to give before QCD age (currently 70 1/2), the DAF is great. After QCD age, use QCDs. At death, leave tax-deferred money.
It doesn’t make sense to do a Roth conversion, pay those taxes and then take the money out of the Roth IRA and put it in a DAF. That’s the whole point of the article. So looks like it is helping at least one other person not make a bad decision.
I wanted to push back a little on your rule of thumb #1 if you don’t fit the very wealthy and extremely charitable mold. No one would dispute that Roth money is ideal for heirs, but after SECURE 1.0 it seems that a taxable account is much better to inherit than a tax-deferred account (assuming the step-up in basis). Wouldn’t that logic lead you to spend down your tax-deferred account in retirement when you are in a relatively low tax bracket instead of having your heirs forced to withdraw tax-deferred funds over 10 of what could be their peak earning years? I concede that it may be worth withdrawing some taxable to take advantage of a 0% capital gains situation, but from your heir’s perspective taxable seems so much more desirable.
To have this discussion we need to clarify what you mean by inherit a taxable account versus a tax-deferred account. As a general rule, I would rather inherit a taxable account than a tax-deferred account even before the New Stretch IRA rules ASSUMING the accounts are the exact same size. Who wouldn’t? But if you adjust the tax-deferred account for taxes first, I’d much rather inherit the tax-deferred account. The only question is in between those two amounts (equal size and fully tax-deferred). Since Secure 1.0, the line where one would rather have the tax-deferred has moved a bit closer toward the taxable account.
There is also the factor you bring up with your heirs and their tax bracket to think about. That’s usually discussed in terms of whether to leave them a tax-deferred account for them to pay the taxes or for you to pay the taxes and leave them a tax-free account of smaller size.
You’ve really just got to think of everything in after-tax terms to make the right decisions.
Hi
Great topic to consider.
Does your plan of living off your taxable accounts mean that each year, once you enter RMD, you plan to donate the $250K-$750K that must be distributed from your $7M IRA?
Thus avoiding earned income tax rates?
Thanks
I’m not sure I’ve ever mentioned the size of our tax-deferred accounts, but I suppose it’s entirely possible they could be $7M or more by the time we’re 75 in 3 decades.
But yes, my current plan is for the entire RMD to be satisfied by a QCD. Then I expect to donate even more from the taxable account each year. More on QCDs here:
https://www.whitecoatinvestor.com/qualified-charitable-distributions/
I just used the numbers from your example above. Perhaps I should have said “example above” instead of “your.”
What an interesting thought exercise! Investing, tax, and legacy decisions start to look a lot different once you reach a certain level of wealth.
One thing you mentioned that I haven’t been able to verify is that one’s entire RMD could be donated as a QCD. My understanding is that we’ll still be limited to $100,000 per person that can be given from an IRA as a qualified charitable distribution, but that number will be indexed to inflation starting in 2024 (thanks to SECURE 2.0).
I’m sure it will change several more times before either of us are 75 or whatever the age is at which RMDs must be taken in the mid-2040s.
Best,
-PoF
Oh you’re right. There is a $100K limit. That’s like a $2.5-3M IRA today at age 75. No big deal for someone giving a lot to charity though because they can still itemize.
Very thoughtful article.
I was going to raise the QCD limit as well. That does change the calculation. As for most of the other factors, one needs to run the analysis using one’s own figures.
I would also run the figures assuming a much lower geometric return than 7.5%. At current high valuations, I use 1% real as my base assumption. One could try incrementally higher returns than that, but 7.5 seems extremely optimistic.
On that topic, I would not include the capital gains taxes to be paid if heirs were to liquidate the inherited taxable assets at 10 years. Unlike the 10 year requirement for distribution from the IRAs, they are under no obligation to liquidate these funds. Ever. They can let the entire amount ride throughout their lives and let their heirs inherit the gains with a stepped up basis, decades later. Or they could spend the dividend income, which would have been taxed each year anyway, and let the gains ride. Either of these would be far more tax efficient than realizing the gains.
If they wanted to spend more than just the income from the taxable account, depending on the interest rates they can get and the size of the gains, they might borrow against the taxable assets and pay interest but no CG taxes. That would require an analysis of the overall effects on their financial situation.
I would think that if the tax deferred account ( or any account, for that matter) one plans to hold forever ( that is, no defined investment horizon) to create a multigenerational wealth, then it should be invested super agressively, with potentially superior results due to a super long holding period and high(er) risk .
I think it’s one of the “priviliges” of truly wealthy people, when you won’t need all of your money for whatever reason after a defined period of time ( like for retirement needs)
I think so. We’re not quite ready to pull it out of our “retirement money” yet, but it wouldn’t surprise me if we do it soon and just start thinking of it as charity money.
Broadly, I agree. But there is no guarantee that a highly aggressive investment approach will pay off, even in the very long term. That is why they call it risk.
This does not change the logic of whether to do a Roth conversion or how to access the money in the taxable account, however it may have arrived.
What? “…your entire RMD can be a Qualified Charitable Distribution (QCD) with no associated tax bill”? I wish! Annual QCD is limited to $100k. RMD can be a *lot* higher than $100k.
Of course you’re right as discussed above.
These are great estate planning ideas and should certainly be considered.
I saw your comment on the monthly newsletter that nobody cared about this article. It was my favorite of the month. I switched my 401k from Roth 401k to traditional 401k.
Thanks for the kind words!