Ep 22 - The Best Account to Inherit - Congress's Gift to Us

Welcome to the Good Steward Law and Wealth Podcast, where host Ledly Jennings explores law and finance to help listeners become better stewards of their wealth. Each episode covers the latest trends and strategies in estate planning, elder law, investment, and wealth management. Tune in for the knowledge and tools for financial success and security.

Welcome back to the Good Steward Law and Wealth Podcast. Glad to have everyone here. And today we're continuing our series. Series on retirement accounts and your estate plan. And we're going to talk about the best account that you can inherit from anyone. What is the ideal retirement account that you can inherit? That's what we're going to hit on today. But to refresh our memory a little bit, previous episodes, and go back and listen to the previous two to learn about what we, what we've already discussed. We started out with discussing IRAs and the new SECURE Act and all the impacts that may have, and then how those IRAs would play with your trust if you make your trust your beneficiary. So those go in depth on some unique issues that this new law change has. But just a quick recap is when you inherit an IRA, it is now subject to a 10-year stretch. Now this is only if, you know, it doesn't apply to a spouse. A spouse can inherit an IRA and get a very good and long stretch of their payments. But if you're leaving your IRA ultimately to a kid or someone that isn't your spouse or underage or special needs, like most of us do, you leave it to your grown children typically, then they are subject to a 10-year stretch. And what that means is they have to withdraw the entire account out within 10 years. So think about the impact of this. If you have a $1 million IRA, then that entire $1 million balance has to be taken out within 10 years. So your child could do it, you know, $100,000 per year for 10 years, or they could wait until year 9 and take it all out. But either either way, it has to come out. And the impact of that is tax consequences because this is all tax-free money or pre-tax money. So, when they take it out, they have to pay the income tax. Meaning at that large amount, like most people's retirement accounts are, it would bump them up to the highest tax bracket in a lot of cases. So, just an example, right now, I think the highest tax bracket is 35%. It keeps bouncing back and forth, but just say that 35%, 37%, if they bumped up into that, then your inheritance that you're leaving them is now reduced by that same amount. So if you can avoid it, you, you want to avoid it so they get 100% of your inheritance rather than just, you know, 70% of it. So that is the downside of inheriting an IRA, and most people don't think about that because it is a new law. But we are lucky that Congress has given us one of the best gifts they've ever given us in the form of the best type of retirement account to inherit, and that is a Roth IRA. IRA. So the best account to inherit is a Roth IRA. Why? Because the tax has already been paid on it. Your child would inherit an account and not owe any tax on it. When they withdraw it, the tax has already been paid. So basically it's a tax-free gift. They inherit it at a 0% tax rate. So if I were to inherit a Roth IRA, I would give my parents or whoever left it to me a hug because it is one of the best accounts that you can inherit. And just why it's good for inheriting is because those taxes are already paid. So it's income tax-free, 0% tax rate, and there are no RMDs. Now it is subject to that same 10-year stretch, meaning you have to take it out of the IRA account at the end of 10 years, but there's no RMDs before that time. So it could sit there and grow and grow and grow for that entire period before you take it out. And then when you take it out, there's no income tax on it. So a Roth IRA is a great account to inherit. It. Now, what is a Roth IRA? Many of you have probably heard of it, and it is a retirement account just like an IRA, but different benefits. So with an IRA, you contribute money before it's been taxed. You take a deduction on your tax return and you contribute it into an IRA. So there's some tax benefits there, but then when it grows, you ultimately pay the tax when you take it out. Now, a Roth is the opposite of that. You pay the tax upfront, you contribute it to a Roth account, and then it grows tax-free. So then you take it out say when you're 70 and you don't pay taxes on it because the tax has already been paid. Some of the rules with the Roth IRA, and these are subject to change every so often, but right now you can't take out your money in a Roth IRA until you're age 59 and a half. I don't know where they came up with that half number, but that's what they decided on. So, at age 59 and a half, anytime after that, you can withdraw your funds. Tax-free. Now, before that, you can still access it for certain reasons like health or education, you know, something that you actually need, and there's no penalty. But if you take it out for any other reason before 59 and a half, there's a 10% penalty. So you could still access it, but there's a penalty. Another difference in this is there's no RMDs with a Roth, and you can contribute. So like an IRA, when you reach 73, you have to start taking RMDs. But with the Roth, you do not. So, and you can also contribute beyond age 73, which is a little different than a regular IRA. So that's generally what a Roth is. Now, how do you contribute to a Roth? Well, the normal way is just you earn, you have to earn income. So you have to have a job, make money. And if you have earned income, you can contribute to a Roth. There's limits. I believe we're at $7,000 per year is your limit that you can contribute into a Roth. Roth IRA. So it's just like IRAs or 401(k)s, there's limits on those, but you can contribute up to $7,000 per year. And then there's also limits on who can contribute to a Roth. So if you are single, let me pull up that number to confirm it hadn't changed on me. If you're single and you make more than $150,000, you can't contribute to a Roth. Roth. So there's limits on who can contribute. Now, if you're married and filing jointly, then that number is $236,000. So if you make under those amounts, you can contribute to a Roth. If you make over those amounts, you cannot contribute to a Roth. Now I say that most people follow the rules that way and think that, oh, I make too much money, I can't contribute to a Roth. Well, that's not necessarily true because there are other ways to get to a Roth account. Beyond your contributions, you can do conversions. Some people, there's rollovers, or what a lot of people are doing now is called a backdoor Roth contribution. So, what this is, is if you make too much money, then you can contribute your money to an IRA, not take the deductions, and then roll it over to a Roth. Now, that sounds a little fishy. It sounds like you're skirting the rules, but actually Congress and the IRS have confirmed that this is okay. This is an okay method because The tax is still getting paid on it. So it's just a way to contribute to a Roth even if you make too much money. Now, I would advise talking with a financial advisor to help you do this because there's a lot of little technicalities about when and how much that you can do this. So I would work with someone that is well-versed in backdoor Roth conversions. And most certified financial planners are, so I would work with someone that is a CFP. The other way you can contribute is just a regular conversion. You can convert your existing IRA to a Roth, and there's all kinds of rules around this, but essentially you have to be able to pay the tax upfront and then convert it. But a lot of people do that because it makes sense financially to do that. And you can also roll over 401(k)s or work accounts to a Roth account, but there's rules in how you do that. Steps you have to take to get there depending on your financial situation. So, just because you make too much money does not mean you cannot contribute to a Roth. So, I just told you, you know, this is the best account to inherit. Everyone loves a Roth. Then you may ask, well, why doesn't everyone do it? Well, one is that rule I just mentioned where if you make too much money, they think you can't. So, a lot of people don't do it for those reasons. But another reason is people fear this sounds too good to be true. Congress is going to come in and change the law and then I will have built my whole estate plan, retirement plan around this, and now it doesn't make sense anymore. That's partly true because I always say the tax laws are written in pencil. It can always be changed. We see a lot changing right now depending on who's in office. And as the, you know, the House and Senate switch back and forth, things change. So tax laws are written in pencil and can be changed. But why I'm not worried about it for a Roth perspective is because of the benefits of Roths to our government. If you think about it, this Roth money is upfront money. So, as soon as you get the money, you're paying the tax on it. And that means immediate money for Congress. So, they're unlikely to change something that is paying them today. Now, if you think about it with your regular IRA, they have to wait till years and years down the road before they get their money. So, it's actually an incentive to Congress to encourage more Roths because they get the money upfront. And you see our deficit that we're in right now, We probably want as much money upfront as we can get. So I see it as very unlikely that Congress would actually change these laws. And then with the SECURE Act and that conversion, backdoor conversion I just mentioned, they've actually enhanced your ability to get into Roth. So it seems like a pro-Roth environment that we're in. So it's unlikely that that'll change. Now, another reason why people don't want to get into a Roth is because they have to pay the tax upfront. You know, you have to pay it now and you don't get the deduction. And this can be a valid reason depending on your particular tax situation. And your advisor can look into this if it makes sense to convert to a Roth. They have Roth calculators that can break down your specific tax situation, your income, you know, all the factors that may go into it and tell you if it makes sense to convert. This particular podcast is just about the estate planning implications of of retirement accounts, and we know that a Roth is best, but if it makes sense for you to contribute to a Roth is more of a financial advisor question. So certainly sit down and run that calculation. But if you do run the numbers, some of the things they take into account is even if you're paying the tax today, if you have a long enough time horizon, then that money is going to grow exponentially more than it would if you kept it in a Roth. So your ultimate take-home pay may be more if you convert it, even if you pay the tax upfront. So, in my situation, I am contributing everything to a Roth right now because of that exact thing. I think in the long run, my tax rate will be higher and what I contribute today will be more valuable to me down the road at a 0% tax rate. So, that's my thought process on it. And that is really the name of the game of when you contribute is what is your tax rate now and what will it be in the future? Now, a lot of people think that their tax rates goes down when they retire.. But I've seen this a lot with my clients. That is typically not the case because most people I work with are good savers, investors. Maybe they are high-income earners now, but even in retirement, their income goes up because now they're getting Social Security. They're having to take RMDs from IRAs. They have investment income. They may have inheritance that comes in. So typically your income goes up in retirement. So your tax rate would be the same or higher. And how I really evaluate it is It always makes sense to convert to a Roth if your tax rate will be the same or higher in the future. So even if it's just going to maintain the same, then it makes sense because you're converting it into a 0% environment in the future. One other thing I would want to hit on is historical tax, income tax rates. So a lot of people think tax rates, you know, they may go up in the future, or maybe we're at a very high tax rate environment now. And if you think that we're in a very high tax rate environment, then you wouldn't want to convert to a Roth because tax rates would go down in the future. But actually, if you look at the chart, tax rates are on sale right now. We're at a discounted historical value when you look at past income tax rates. So, it makes a lot of sense from that perspective to convert to a Roth. And so, let's just say in 1944, '44 to '45, income tax, the highest marginal tax bracket was 94% compared to today, which is, you know, 30%. And then in the 1950s and early '60s, it was 91%. In the '70s, it was 70%. So it has been very, very high. In the '80s, before Reagan's tax cuts, it was 50%. But then with those tax cuts, it was brought down to 28% by 1988. So at that perspective, tax rates Markets are on sale right now, and it makes a lot of sense to do conversions or contribute to a Roth because if we look at the history of our income tax rate, it's going to go up. Maybe that's not the case, but that's just what the history shows us. One other thing I wanted to hit on too, why Roths make sense from an inheritance perspective, and we call this the widower's penalty. So most husbands, wife leave their retirement accounts. To each other. And there's actually a penalty that not a lot of people think about when we talk about widowers inheriting an account. Because when you inherit an account, you're married filing jointly, but when one spouse passes away, all of a sudden you're now a single taxpayer, so you're filing single. That means you have to pay more taxes on less income. Is essentially what that means. But if you would have converted to a Roth, it helps the surviving spouse out a whole lot. It only improves their situation because they don't have to worry about this widower's penalty. Because actually, when a spouse inherits, they may lose some income because of the loss of Social Security, but they are gaining the income in some RMDs and, you know, retirement accounts. But now they're paying higher taxes on less income because they are single filing single rather than filing jointly. So that's the reasons people don't contribute to a Roth, but otherwise it always makes sense to contribute to a Roth, especially if you're going to inherit something, because again, it is the best account to inherit. Now, when I'm advising people what they need to roll over to a Roth or convert is they need to have the income to pay the taxes right then. So you don't want to pay it from your actual Roth— I mean, from your IRA account. You want to have other liquid assets to pay the tax. So if you have the ability to pay the tax, then it could make sense to convert to a Roth. And the other reason you need to do it and look out for is if you have a long time horizon. So if you have, you know, 20 years or more before you're going to actually need the money, or it's going to be able to grow for about, you know, 10 to 20 years. Over 10 years, it starts to make sense, 20 years for sure, then you can convert to a Roth because you have a long time horizon to let your money grow tax-free. Tax-free. And you definitely do not want to start taking them if you're already taking your RMDs. So if you're over 73, then converting to a Roth is not usually a good idea. But generally, the best account to inherit is a Roth because it is tax-free money. So that is the takeaway I wanted to say for this episode, is that when you leave your beneficiary a Roth account, they don't pay taxes on it. So it almost always makes sense to do that. And it varies. About each situation, so always talk with your advisor. But when I am advising clients on how to name your beneficiaries, if there is a Roth account, then it is always a good thing to leave that to them because you're getting the most bang for your buck. And that has been the Good Steward of Law and Wealth Podcast. Thank y'all for listening. And I'll see you next time, and we will talk about an overall beneficiary plan for your retirement account.

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