People worry about taxes on traditional retirement accounts.
During the owner’s lifetime, those worries are largely unfounded. On my YouTube channel I’ve demonstrated that even those with surprisingly large traditional IRAs are likely to pay modest effective tax rates during their own retirements.
Spreadsheets tell us the chances we will pay high taxes on our own traditional retirement accounts are rather low.
Inherited Traditional IRA Tax Concern
Spreadsheets also tell us that in many, though certainly not all, cases, our heirs are likely to pay a higher tax rate on our retirement accounts than we will.
Picture an 80 year old retired married couple. In order for a dollar of their required minimum distribution (RMD) to be subject to a 24% federal income tax rate, their taxable income in 2026 would need to be at least $211,401. In order for a dollar of their RMD to be subject to a 32% federal income tax rate, their taxable income would need to be at least $403,551.
In a world with a high standard deduction, an additional standard deduction, a senior deduction, and qualified charitable distributions, these levels of taxable income are relatively uncommon for married retirees.
During the owner’s life, RMDs go on top of Social Security income and investment income such as interest income. RMD percentages are quite modest. For those 75, the required distribution is only approximately 4.07 percent of the prior year-end account balance. It rises to 4.95 percent at age 80 and 6.25 percent at age 85.
For those inheriting traditional IRAs (beneficiaries), high levels of taxable income are more common. With inherited IRA distributions over the 10 year window on top of W-2 salary and bonuses, it is very possible Junior will pay tax rates on Mom and Dad’s IRAs in excess of the tax rates Mom & Dad paid on their RMDs.
For the beneficiary, in most years the inherited IRA distribution is likely to be 10 percent or more of the inherited IRA starting balance to smooth out the taxes paid over the 10 year window.
The Inherited Traditional IRA Concern Remedy
The potential remedy for the inherited IRA concern is easy: Roth conversions during the owners’ lifetimes.
On a spreadsheet we can easily justify this remedy. Perhaps Mom and Dad would pay a 22 percent marginal statutory federal rate on Roth conversions. Such conversions might reduce their senior deduction, increasing the effective federal income tax on the conversions from 22 percent to 24.64.
The potential 2.64 percent “surtax” is created by every dollar of Roth conversion reducing the senior deduction by 12 cents on the dollar. Multiplying 12 cents on the dollar by a 22 percent statutory rate gets us to 2.64 percent.
Imagine Mom and Dad’s adult children all pay a marginal tax rate of 32 percent. Mom and Dad doing Roth conversions at a 24.64 percent effective tax rate would, intergenerationally, save the family 7.36 cents on the dollar in federal income taxes (32 minus 24.64).
Thus, assuming relatively high income beneficiaries, the spreadsheet says “Yes” when it comes to owner Roth conversions for the beneficiary’s benefit.
The Windfall Problem with Roth Conversions
Spreadsheets are great. But they should be ignored if following them disregards common sense.
Those using spreadsheets to argue Roth conversions are necessary to avoid higher beneficiary taxes on inherited IRAs argue that retirees not experiencing a financial windfall should pay more in taxes to benefit future beneficiaries experiencing a financial windfall.
Spreadsheets matter in financial planning.
Personal profiles matter much more.
Financial planning should ask “who benefits?” and, generally speaking, steer benefits to those in the family in most need of them. Adult children beneficiaries enjoying a financial windfall tend to need much less in financial benefits than those not enjoying a financial windfall.
Retirees funding their living expenses from their IRAs and 401(k)s are living off their own assets. Retirement accounts are not a windfall to them. Rather, those accounts are their deferred career earnings and growth thereon.
Inherited retirement accounts are a financial windfall for beneficiaries. They stack on top of other resources, including W-2 income and the beneficiary’s own accumulated financial wealth.
Why should someone not enjoying a financial windfall do financial planning for the benefit of someone enjoying a financial windfall?
Why should retirees pay additional taxes for the future benefit of their adult children who will receive a financial windfall?
This is not to say wealthy, elderly parents should not do Roth conversions to benefit their adult children as future retirement account beneficiaries. It is to say Roth conversions for the benefit of adult children who will experience a financial windfall are not necessary.
I am not opposed to some wealthy retirees making a value judgment that intergenerational tax arbitrage is desirable. For those making such a value judgment who can afford to pay the taxes, great, do Roth conversions for the benefit of the next generation.
But to say such planning is necessary ignores the reality that Roth conversions done for the benefit of the next generation require sacrifice by those not enjoying a financial windfall for the benefit of those who will enjoy a financial windfall.
Extra Note: You might be asking, “But Sean, what about my ne’er-do-well adult child? Shouldn’t I do Roth conversions for their benefit? They will need my retirement account.” The odds are very good that the ne’er-do-well beneficiary would pay a low tax on the retirement account, since they have little other income. A parent’s Roth conversion might hurt the beneficiary by increasing rather than decreasing the effective tax rate on the parent’s retirement account and reducing the amount of taxable assets the ne’er-do-well beneficiary inherits, since some of the parents’ taxable assets are used to pay the income taxes on what might ultimately be inefficient Roth conversions from an intergenerational perspective.
Conclusion
Those arguing Roth conversions to reduce taxes on inherited traditional retirement accounts are desirable ignore the Roth conversion windfall problem. It is illogical to say that those not enjoying a financial windfall need to pay more tax for the benefit of those enjoying a financial windfall.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
Follow me on LinkedIn at @SeanWMullaney
This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.