Rethinking How IRAs Fit Into Your Estate Plan

Retirement accounts — such as IRAs, SEP IRAs, 401(k)s, and 403(b)s — are the primary long-term savings vehicles for many American families. Since the Roth IRA was introduced in 1998, advisors have written extensively about when it may be advantageous to convert traditional retirement assets into Roth accounts. However, most of this guidance has focused on individuals who plan to use these assets to cover living expenses in retirement.

For wealthy individuals who don’t rely on these assets to support their lifestyle in retirement, the question fundamentally changes. Should these traditional accounts be left to charity, as has often been advised? Or might a Roth conversion offer a more effective strategy for estate planning and wealth transfer?

Traditional IRAs vs. Roth IRAs: Key Differences

Traditional IRAs are tax-deferred accounts that are subject to mandatory required minimum distributions (RMDs) starting at either age 72, 73, or 75, depending on the account owner’s birth year. Regardless of the underlying investments, all distributions are taxed as ordinary income.

Roth IRAs, by contrast, are tax-free accounts that are not subject to mandatory RMDs. This allows the account to remain untouched until death. Heirs must fully distribute the account within 10 years, but those distributions would be entirely tax free.

Conventional Advice: Leave IRAs to Charity

Where charitable bequests are part of an estate plan, advisors often recommend designating some or all of the remaining IRA balance to charity at death — typically at the passing of the surviving spouse in the case of married couples. For purposes of this article, we assume that any existing retirement account balance — in vehicles such as a 401(k), SEP IRA, and 403(b) — is rolled over to a traditional IRA at retirement.

Leaving a traditional IRA to charity instead of heirs eliminates the embedded income tax on distributions, as charities are tax-exempt beneficiaries. Unlike other assets, inherited retirement accounts do not receive a step-up in basis, making this an attractive planning strategy for some individuals. However, one drawback is that traditional IRAs must begin RMDs by age 75 at the latest, based on an actuarial IRS life expectancy table. These annual withdrawals generate ordinary income and can significantly reduce the IRA balance before the surviving spouse’s death — potentially limiting the intended charitable benefit.

Why Consider a Roth IRA Conversion?

Converting a traditional IRA to a Roth IRA transforms a tax-deferred account into a tax-free one, leaving more for beneficiaries. The tradeoff is that the amount converted is included in the account owner’s taxable income in the year of conversion and is subject to federal — and, in most cases, state — income tax. An exception may apply in certain so-called “backdoor” Roth strategies involving after-tax contributions. However, as previously noted, once converted, all future growth is tax free, with no required distributions during the account owner’s lifetime.

For those who can afford to leave the account untouched during their lifetime, the Roth IRA will continue to grow tax-free for life — and for an additional 10 years after death, when under current rules, the full balance must be distributed.

Reducing the Income Tax on a Roth Conversion

There are a few strategies that can potentially be employed to reduce or even eliminate the income tax triggered by a Roth conversion. Common approaches include realizing a loss in the current year or accelerating deductions — particularly charitable contributions — to offset the income generated by the conversion.

While these strategies are generally effective for federal tax purposes and in many states, several states — including Connecticut, Illinois, and New Jersey — don’t allow deductions for charitable contributions, which may limit their impact.

For individuals planning to leave a specific asset or dollar amount to charity at death, accelerating those gifts — or their present value — into lifetime contributions can be a highly effective way to mitigate the tax cost of a Roth conversion. A donor-advised fund, such as the Bessemer Giving Fund, provides a flexible and efficient way to accelerate the deduction, while maintaining control over the timing and direction of future grants.

Individuals whose taxable income comes primarily from investment portfolios may find this approach especially beneficial. Accelerating charitable contributions can help offset income related to Roth conversions and maximize the tax benefit of lifetime charitable contributions. That’s because the ordinary income associated with a Roth conversion will often push individuals into a higher marginal tax bracket in the year the conversion takes place.

Let’s examine how this might work in practice:

Frank and Marie, a retired couple in Florida, are both 70 years old. They have a $1 million traditional IRA and a total net worth that will result in a taxable estate. They do not expect to need the IRA for living expenses and plan to leave the account to their children. They are evaluating three strategies for how to handle the IRA:

Option 1: Retain the traditional IRA. Starting at age 73, they must take annual required minimum distributions, even if they don’t need the income. These distributions are taxed as ordinary income and gradually reduce the value of the IRA over time. When they pass away, their children inherit whatever remains of the IRA and must withdraw the full balance within 10 years, paying income tax on those withdrawals at a 37% federal rate.

Result:

• Annual RMDs reduce the size of the account over time.
• Their children receive a taxable inheritance.
• This results in the lowest total wealth transferred to children of the three options.

Option 2: Convert to a Roth IRA. Frank and Marie convert their $1 million traditional IRA to a Roth IRA. They pay approximately $370,000 in federal income tax (at a 37% marginal rate) using non-IRA assets. Because Roth IRAs do not have RMDs during the original owner’s lifetime, the full account can grow tax-free. Their children inherit the Roth IRA and can withdraw the funds over 10 years, entirely tax-free.

Result:

• No RMDs, enabling full tax-free compounding during Frank and Marie’s lifetime.
• Their children inherit a tax-free asset.
• Compared to retaining the traditional IRA, this strategy increases total wealth transferred to their children by approximately $1.2 million.

Option 3: Convert to a Roth IRA with charitable offset. Frank and Marie convert the traditional IRA to a Roth IRA, but in the same year, they make a $1 million lifetime charitable contribution using a donor-advised fund. This approach also allows them to take their time in recommending charitable grants. The Roth IRA continues to grow tax-free and is ultimately inherited by their children. We have assumed that the $1 million charitable contribution is fully deductible and offsets the Roth conversion income, eliminating the $370,000 tax liability.

Result:

• They avoid paying tax out of pocket, preserving their non-IRA assets for other uses or for heirs.
• The account permits tax-free growth and tax-free wealth transfer (similar to Option 2).
• Compared to retaining the traditional IRA, and by accelerating charitable gifts at death into the year of the Roth conversion, this strategy increases total wealth transferred to their children by approximately$2.5 million.

These outcomes are based on Bessemer’s comprehensive proprietary Roth conversion analysis, which employs a variety of assumptions — including a pretax annual growth rate of 7.2%, an after-tax annual growth rate of 6.1%, and a federal income tax rate of 37%, among others. Individual results will differ based on actual tax rates, rates of return, and states of residency for IRA owners and beneficiaries.

As these examples illustrate, converting to a Roth IRA (Option 2) results in a significantly larger wealth transfer than leaving the IRA intact. The strategy becomes even more compelling when paired with a charitable offset (Option 3), which eliminates the income tax cost of conversion.

Coordinating Beneficiary Designations

Clients who decide to employ a Roth conversion strategy should review their beneficiary designation forms and, where applicable, remove charitable organizations as the ultimate beneficiary. For married couples, this typically means naming each other as primary beneficiaries and their desired heirs as contingent beneficiaries. Unmarried individuals should name their heirs as primary beneficiaries.

Coordinating the Roth conversion with your overall estate plan is essential — particularly if you wish for assets to pass automatically to a beneficiary’s children if that beneficiary passes away before you do (known as a per stirpes designation), or if you plan to name trusts as beneficiaries. Be sure to review these decisions with your estate planning advisor to ensure they align with your overall objectives.

Additional Tax Considerations

Clients living in tax-friendly states, whose heirs reside in higher-tax jurisdictions, may see added benefits from a Roth conversion. Conversely, if heirs live in lower-tax states, the benefit of conversion may be diminished — since they would owe less on RMDs from inherited traditional IRAs.

It’s also common for retired affluent individuals to assume they’re still in a higher marginal tax bracket than their heirs, which may discourage them from a Roth conversion. However, that’s often not the case when their income comes predominantly from investment portfolios while their heirs are in their peak earning years. In such cases, a Roth conversion may result in an even larger after-tax inheritance. Qualified dividends and long-term capital gains are taxed at a top federal rate of 23.8%, while earned income can be taxed up to 37%. And, of course, future tax rates remain unpredictable.

What About Qualified Charitable Distributions?

Qualified charitable distributions (QCDs) permit IRA owners age 70½ or older to contribute up to $108,000 annually directly from their IRA to a qualified charity. However, QCDs cannot be directed to private foundations or donor-advised funds. For eligible individuals, QCDs can count toward RMDs. That said, our modeling suggests that donating long-term appreciated securities is often more advantageous than using QCDs — particularly for clients pursuing Roth conversions as part of a generational wealth transfer strategy.

Is a Roth Conversion Right for You?

Since the Roth IRA’s introduction in 1998, Bessemer’s Client Tax Services Group has conducted extensive modeling to evaluate the benefits of Roth conversion. We have determined that Roth conversions are most effective for clients who:

• Don’t need their retirement accounts to fund their lifestyle
• Don’t expect income tax rates to decline significantly in the future
• Have sufficient non-IRA assets to cover the tax liability triggered by the conversion

When these conditions are met, Roth conversions can be a powerful tool to enhance wealth transferred to the next generation.

Importantly, Roth conversions can be implemented gradually over multiple tax years¹ — in whole or in part. Unlike other wealth transfer strategies, Roth IRA assets remain under the owner’s control during their lifetime. This means that if circumstances change and the funds are needed, the account remains fully accessible, providing tax-free withdrawals to the owner.

Next Steps

Reevaluating how your IRAs and other retirement accounts fit into your estate plan may unlock new opportunities for tax efficiency and wealth transfer planning. To determine whether a Roth conversion is right for you, please contact your Bessemer advisor or tax professional. Our team can provide a personalized Roth conversion analysis tailored to your family’s estate planning objectives and overall financial picture.