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:

  1. Increase our asset protection,
  2. Facilitate estate planning,
  3. Decrease total income taxes due (since we're likely to spend the rest of our lives in the top tax bracket), and, most importantly,
  4. 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:

  1. You should spend down your taxable account before touching your retirement accounts, whether tax-deferred or tax-free.
  2. Roth accounts are best left to heirs since there are no taxes due and they can be stretched for 10 more years.
  3. Tax-deferred accounts are best left to charity since neither you nor the charity will pay taxes on any of that money.
  4. 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.
  5. 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:

  1. We're going to live the rest of our lives just fine solely off of our taxable account, assuming we ever stop working!
  2. We're going to leave more to charity than we will ever have in tax-deferred accounts.
  3. 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.

wealthy charitable people roth conversions


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!