401k to IRA to Roth for my mom?

[CCCA]

Hi,
I've been helping my mom with her retirement accounts.  She's 73 and has been taking RMDs from her 401k which is sizeable.  She is pretty mustachian and can live on her SS income plus interestidends on her other taxable investments.  She is required to take RMD which  which stated that for currently amounts to an additional 40k or so per year.  The point is she doesn't really need the RMD to live and she'll just invest it in taxable investments.  She is also in good health and we think she should live well into her 90's at least.

I'm annoyed by her 401k provider (TIAA-CREF) partly because I'm used to dealing with Fidelity which seems much more user friendly (at least the online tools), and also for the limited choices she has in investments (though at least the expenses are low (~ .1%). 

But I was reading the "Retirement Time Bomb" which stated that IRAs are much better than 401ks for estate purposes, since you are required to liquidate a 401K within a few years after inheritance, incurring substantial taxes, whereas the required withdrawal from an IRA is over a much longer period of time.  So I was thinking of switching most of her 401k money into a Fidelity IRA.  About half of her 401k is in traditional TIAA annuity, which has a guaranteed rate of 3% return and is currently at 4.2% so maybe just moving half to Fidelity and leaving the TIAA annuity alone until she is a bit older. 

The main question I have is does the roth conversion make sense for her, since she does not plan to use most of her IRA.  I know that roth conversion is done after her RMD, so she'll take a 2nd tax hit for doing the conversion (she's at the 25% tax rate given she's single and her RMD is so large and just the standard deduction and makes her SS income mostly taxable as well).  It's mostly a tax question for inheritance.  It seems like the Roth vs Traditional debate makes sense here as well.  But the Roth also doesn't require RMD, so as we convert the IRA to Roth over time, the RMDs will affect less and less of her retirement accounts, which is handy since she doesn't really need to withdraw from her retirement accounts except to satisfy the IRS.  Also inheriting a Roth is much better than a traditional IRA since the will both grow for a long period of time and later we can withdraw without taxes.

Overall it seems like the 2 step conversion 401k --> Traditional IRA and then --> Roth makes sense though I will be double checking on the taxes and how it'll affect her RMD requirements in the future.  Is there anything I'm missing?

[dandarc]

Not sure I'd do the Roth conversion at 25%, but I would roll the 401K to an IRA, just for flexibility and to get into a "standard" set of rules.  What does the specific 401K say regarding the time-frame for withdrawing an inherited account?  Seems to vary by plan from "Lump sum only" to "over the life of the beneficiary (same as an IRA)".

How many heir's are there?  If the account gets divided among many people, it seems likely to me that RMD's will be lower, and therefore potentially at a lower tax rate than they are for your mom.

[CCCA]

Not sure I'd do the Roth conversion at 25%, but I would roll the 401K to an IRA, just for flexibility and to get into a "standard" set of rules.  What does the specific 401K say regarding the time-frame for withdrawing an inherited account?  Seems to vary by plan from "Lump sum only" to "over the life of the beneficiary (same as an IRA)".

How many heir's are there?  If the account gets divided among many people, it seems likely to me that RMD's will be lower, and therefore potentially at a lower tax rate than they are for your mom.

Actually I forgot to mention that she's right at the SS tax "cliff", in that with only her SS income she doesn't pay any federal tax on her SS income, but with her RMD added, she pays taxes on her full RMD + 85% of her SS income, so the marginal tax rate for her RMD is pretty high (around 45%, though the average of her entire RMD is around 20%), so paying 25% to convert to a Roth but also not having to take RMD on it in the future could help reduce future taxes. 

2 heirs so not as much splitting to reduce the RMDs.  We are very close to FIRE, probably a year or so, or even less, if the market continues like it is today.

[dandarc]

I see - so the idea is to convert to Roth to save taxes later but still during her lifetime due to lower RMDs.  Makes sense.

Just know the up-front cost is high and certain, and the payoff will likely take quite a few years to accumulate, and there is a possibility it won't happen - basically you're betting on Mom living a long time, and tax rates staying roughly where they are now for that long time.

Out of curiosity, how big is the account?  If you're OK with paying 25%, are you also OK paying 28% or 33%?  Are there also state or local taxes to consider?  The faster you get the traditional account reduced, preferably to 0, the better the odds of this plan working out.  Unless a large income tax cut happens after you've converted, of course.

[CCCA]

I see - so the idea is to convert to Roth to save taxes later but still during her lifetime due to lower RMDs.  Makes sense.

Just know the up-front cost is high and certain, and the payoff will likely take quite a few years to accumulate, and there is a possibility it won't happen - basically you're betting on Mom living a long time, and tax rates staying roughly where they are now for that long time.

Out of curiosity, how big is the account?  If you're OK with paying 25%, are you also OK paying 28% or 33%?  Are there also state or local taxes to consider?  The faster you get the traditional account reduced, preferably to 0, the better the odds of this plan working out.  Unless a large income tax cut happens after you've converted, of course.

That's the idea, but I'm not entirely sure if it'll work.  Probably have to do some more detailed simulations with Turbo tax and some spreadsheets to see if one makes more sense than the other.  But yes, the RMD is taxed very heavily, so reducing that requirement by going to a Roth could help. 

The 401k is at $1.1 million (she did a great job saving, and the market did a pretty good job over the last 30 years compounding her savings). 

[Catbert]

I'm sorta in your Mom's situation except that I'm 9 years younger and most of my tax sheltered money is in IRAs rather than 401ks.  For the past 5 years I've been doing Roth conversions of 50K per year.  That takes us roughly from the bottom to the top of the 25% bracket.  Market gains mean that the account isn't much smaller than it was when I started.  I'm not sure if that's the good news or bad.

I'll mostly stop Roth conversions when RMDs start.  If RMD is less than the 50K I've been converting then I might convert up to that point.  At 73 I suspect that any long term tax saving for her doing conversions will be for her heirs and not her.  If her RMDs put her firmly in the 25% bracket then maybe she wants to convert whatever it takes to fill the bracket.

I think converting 401K to tIRA is a great idea.  Greater flexibility for picking investments.  Plus she could move to Fidelity especially if you're going to manage her withdrawals.
   

[Catbert]

If you are talking about doing very large Roth conversions just to get it over with, check to see the potential impact on Medicare.  Yes, Medicare.  There is an income point (somewhere in the 250K range IIRC) where Medicare Part B premium isn't subsidized by the government and is much larger than the $100 a month she's use to.  People often find this out when they sell property and have a sizeable capital gain.  The really ugly part is that SS doesn't figure this out until a couple of years later (bouncing tax returns against their records) and then come collecting the money.

[dandarc]

Nice - so she's a millionaire next door.

I guess the way to approach this is to figure the tax on conversions, then figure "future" tax saved with the corresponding lower RMD, and figure the break-even point.  If break-even is close enough, do it, otherwise don't.

If I had determined this was a good move at the 25% bracket, I'd probably be willing to do this up to the top of the 28% bracket as well - that gives you another 100K of conversion space to work with, so you can make a larger impact on the Traditional-Roth split each year.  That's a practical consideration - every additional year you take in the conversion phase is one less year of maximum returns in the form of lower taxes later.

I played around with the calculator here:
https://www.calcxml.com/calculators/how-much-of-my-social-security-benefit-may-be-taxed?skn=#results

Obviously, don't have all the specifics, so I went with 10K Dividend, 40K RMD, then 25K SS.  $5300 in tax on the SS benefits.  With those numbers, you have to get the RMD down to about $33K to start seeing the "taxable SS" percentage start going down.  With that starting point, not sure this is worth it - you'd have to convert a large portion of the account just to start saving a small amount of tax on the SS income.

So now I'm thinking "don't do it!".  Since she's probably not moving tax brackets, even if the RMD goes to 0, the savings on the conversion come only from reducing the the taxable % on SS income.  But the most tax you can save from this is about $5300 per year (according to the calculator with a 25% marginal rate).  What's an acceptable break-even?  10 years?  So you'll save $53K over 10 years.  You're paying 25% to do the conversion, so you'd have to be able to pull this off by converting $212K or less of the account for this to make sense.  The problem is, that's under 20% of the account - the RMD will still be quite high, so you didn't actually save the full $5300 in taxes on SS until nearly the whole account is converted.  at 25%, converting 1.1M costs over $250K - gonna take a very long time to break-even on that on $5K or even 10K per year.

Run your own numbers to be sure, but a plan that requires 20 or 30 years just to break-even, at this point, doesn't seem wise to me.