09 Mar ‘Generational arbitrage’ with dad’s money

Q. My father is 79 and has $2 million in his IRAs and I’m his only heir. He’s invested only in bonds and cash. I think he can afford to invest aggressively (for my benefit) as he will never spend all his money. Do you think I’m right? How can I convince him?
— Planning ahead

A. Congrats to your father for having accumulated a decent size nest egg.

But are you sure your crystal ball is accurate and that he will “never” spend all his money?

And how would you feel if your father invested his IRA aggressively and then we experience another financial crisis like 2008/2009 and his IRA declined significantly in value? Would you think he made the right decision?

An important factor in retirement is being comfortable and confident that your money won’t run out, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.

“Your father might have some issues with running out of money or being worried that his IRA accounts take a slump,” McCarthy said. “A good starting point is to have a conversation with your father about the money that he is thinks he won’t need in retirement.”

The amount he won’t need could be moved into a separate IRA and invested according to an appropriately aggressive without compromising your father’s needs, McCarthy said. Or you could propose what McCarthy calls a “generational arbitrage” strategy for any amount your father feels he won’t need personally.

Here’s what he means.

When traditional IRAs are inherited, the beneficiary becomes responsible for paying income taxes on the inherited IRA as distributions are taken, McCarthy said. When Roth IRAs are inherited, any distributions the beneficiary takes are generally income tax free.

“Therefore, it is most likely in your best interest to inherit a Roth IRA rather than a traditional IRA,” he said.

Converting a portion of your father’s IRA into a Roth would require paying income taxes on the converted amount now, he said. Assuming your father is in a lower income tax bracket than you are, you could propose paying the income tax bill for him.

“Someone has to pay the income taxes on any traditional IRAs – either the IRA owner or the beneficiary,” he said. “If the owner is in a lower tax bracket it makes sense to have the taxes incurred at a lower rate.”

Now let’s talk arbitrage, which is the practice of taking advantage of a price difference between two or more markets – in this case two different income tax rates.

Essentially, McCarthy said, you get to pay the income taxes on your future inheritance at your father’s lower rate – hence the “generational arbitrage.”

McCarthy said he’s successfully implemented this strategy with some multi-generational clients.

“Generally, we convert a portion of the traditional IRA each year up to an amount that keeps the IRA owner in a lower tax bracket than the beneficiary,” he said. “The money in the Roth is generally invested aggressively because of a unique benefit in the Roth conversion process.”

McCarthy said the “recharacterization” rules allow you to undo or reverse a Roth conversion up until Oct. 15 of the year following the conversion.

“If the investments in the converted Roth grow in value, that’s a win-win. You paid taxes on the lower `converted’ amount,” McCarthy said. “If the Roth investments decline in value, you recharacterize them back into the Traditional IRA and no income taxes are due. It’s a rare opportunity in the tax code for a free `do over.'”

He said while coordinating with the client’s tax advisor, he generally does the conversions in January each year to give the longest possible window — 22 months until Oct. 15 of following year — to see if the investments grow.

So what strategy is best for you? McCarthy said there’s more to this than just money.

“Take it from someone whose father passed away at age 39,” he said. “I would be grateful to have my father still alive regardless of the value of his retirement assets.”

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This post was first published in March 2017.