02 Jul Will mom have to pay taxes after a Roth IRA conversion?

Q. If my mother, 72, converts the IRA she inherited 14 months ago when my father passed, and then she makes a withdrawal from the Roth IRA in less than five years, will that the earnings associated with that withdrawal be taxable? If she dies within five years and I inherit the Roth, will those earnings be taxable to me?
— Tax-concerned

A. The key here is what your mom did with the IRA when it was inherited from your dad.

She had a choice to put the funds into her own IRA or she could have established an inherited IRA.

That makes a big difference.

If she rolled her husband’s IRA into her own IRA, then she’s good to convert, said Jeanne Kane, a financial planner with JFL Total Wealth Management in Boonton.

But if she put the funds directly into an inherited IRA, she can’t do the conversion from that account.

Let’s go into greater detail.

“As a spouse, mom can convert the IRA, assuming she rolled her husband’s IRA into her own IRA, into a Roth IRA,” she said. “If she transfers a pre-tax IRA to after-tax IRA, the tax-deferred vehicle becomes tax-free for life.”

To convert, your mom would pay ordinary income taxes today and then never has to pay taxes on her withdrawals again, assuming that she meets the five-year rule, Kane said.

Kane said she recommends your mom pay for taxes from outside of the IRA when she converts. Otherwise, she’ll eat into the principal she’s converting.

“All things being equal, the rate of return is generally higher for a Roth IRA because no taxes are due for any gains in a Roth IRA — and taxes reduce the returns you achieve,” she said. “It usually makes sense to pay for a conversion with the assets that will earn a lower after-tax return — taxable assets already outside of the Roth IRA.”

Kane said she doesn’t recommend the conversion unless the plan is to avoid distributions for at least five years.

That’s because of what’s called the five-year rule.

“If mom converts to Roth IRA and holds the money for less than five years, she’ll be taxed on the earnings from the amount converted,” Kane said.

Kane noted the amount that she converted isn’t subject to tax when she takes it out. She already paid that when she converted it.

The five-year clock starts on Jan. 1 of the year your mom does the conversion. There is a separate clock for each conversion done, she said.

If you as the child inherit the IRA, the date of your mom’s conversion won’t matter because new rules will apply for the beneficiary of the Roth, Kane said.

There are no taxes on any distribution, she said, but under new rules, you will have to withdraw all the money in the account within 10 years. If you don’t need the money, you can benefit from 10 years of tax free growth.

But let’s go back to your mom and talk about taxes.

Does she want to do the conversion so she will have tax-free distributions and no required distributions? Or does she want you to inherit the money tax-free?

“For example, if you’re in a much lower tax bracket than your mom, it may make more sense to leave you an IRA versus a Roth.” Kane said. “That’s because it may be better for you to pay lower taxes in the future than for your mom to pay higher taxes now.”

Given the complexities, you and your mom should speak to a financial and tax professional who can help guide you to make the right decision.

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This story was originally published on July 2. 2020.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.