ROTH Conversion vs Stepped Up Cost Basis in Taxable Account

[Safe Harbour]

So I have been struggling with a decision on passing on some money to my children. Should I use a ROTH conversion? My tax guy and my investment guys advice is that it is pretty much a wash. Either pay now or pay later.

The alternative is to leave some of my mutual funds in my taxable account untouched to pass on. Some of the funds are 70% gains now if I sell them. But that would step up to 100% cost basis on my death. The advantage, as I see it, is that there are, unlike the ROTH, no tax implications. That is I don't have the taxes consequences I would have for the ROTH conversion, where I would have to pay income tax on my IRA withdrawal. In the case of the ROTH conversion, I could pay the tax out of cash (CDs) held in my taxable account for the conversion. But ultimately if I convert all my IRA I would have to take living expenses out of my Taxable account which mean sell some of these highly appreciated mutual funds and paying the tax on that too (in addition to the conversion tax).

It seem to me a conversion is a pay tax now or pay tax later question, while passing on highly appreciated mutual funds in the taxable account is a skip paying tax all together strategy? It seems the appreciated asset is a better strategy?

Am I missing something? What do you think?

 

[TheWizard]

A mix of all three types of accounts is fine.
No need to go way overboard with Roth conversions.
We would need more info on the sizes of those accounts, along with your AGI before any Roth conversions to give you better advice...

 

[SecondCor521]

There are three things I think you might want to consider:

1. The current administration has proposed getting rid of the step up in basis at death. This is a topic which can't be further discussed as it is against forum rules, but it is something that is reasonable for you to be aware of to evaluate how much you want to rely on this feature of the tax system remaining in place until you die.

2. You might want to have your tax guy show you the math s/he used to determine that it is a wash. Roth conversions can be a wash for some people, detrimental for others, and highly beneficial for some. I'd especially check that their assumptions and starting conditions and data that they put in their model are accurate for you specifically.

3. When you die and pass along your traditional IRA, your children will generally be required to withdraw their entire inherited balance in the ~10 years after your death. Generally they will owe ordinary income taxes on that. What you might want to do is some rough math to figure out what that tax impact will be. Because of the relatively short time frame, if you have some combination of a large traditional IRA and few children, it may bump them up a tax bracket.

For example, if you had a $3M IRA and three kids, each kid would get $1M. That $1M would be distributed over 10 years. Assuming no growth, that'd be $100K a year in additional taxable income on top of whatever they're earning at their job. That could move an ordinary single taxpayer earning $50K at their job from the 12% bracket to the 24% bracket for those 10 years.

 

[RunningBum]

Under the current tax rules, leaving funds with the largest gains is most efficient. Neither you nor your heirs pay the tax on the gains.

 

[NgineER]

There are some additional wrinkles as well... But you should take a holistic look and do a bit of all.

I think it depends on how much money you have to convert, your converting time frame, your current age, your marital status and whether you have an established Roth IRA already?

Do you have a lot in your tIRA that would impact your children during their compacted 10 year depletion time frame
Do you need a decade to do it, or won't it take very long? If you are at an age where you have not yet started pulling SS, it would likely be better to convert now to even out your tax impact. If you can convert your tIRA over the next decade, you can start withdrawing your contributions to the Roth for spending after five years. If you are married, you or your spouse would be impacted when filing as a single upon one of you dying, if you are single this doesn't matter.
If you already have a Roth established, you can withdraw the contributions for spending and would not have to sell the appreciated stock for spending after your CDs are depleted.

 

[Exchme]

Yes, the math is very individual and is driven by your account balances, age, SS, pensions, other income, need and ability to get ACA subsidies, your children's assets and income and your goals (charitable giving? maximize after tax inheritances?).

Your advisors need to be interviewing you about your goals and your children's financial situation and putting it in a model and updating it annually as returns, life situations and tax laws change.

The bigger question is whether you really need a financial advisor. If you are using a fee-only advisory, that's great, but if the advisory relationship is typical, you are losing more than you might realize. Most firms are looking to take 2% of your assets each year with a combination of advisory fees, loads, fund management fees, transaction fees, etc. Often these are well hidden and hard to see (we had an advisor for a while and he always talked about the advisory fee and how reasonable that was, but that was really just the tip of the iceberg). Over a 30 year investing lifetime, a 2% fee can take half your portfolio!

 

[EastWest Gal]

Yes, the math is very individual and is driven by your account balances, age, SS, pensions, other income, need and ability to get ACA subsidies, your children's assets and income and your goals (charitable giving? maximize after tax inheritances?).

Your advisors need to be interviewing you about your goals and your children's financial situation and putting it in a model and updating it annually as returns, life situations and tax laws change.

The bigger question is whether you really need a financial advisor. If you are using a fee-only advisory, that's great, but if the advisory relationship is typical, you are losing more than you might realize. Most firms are looking to take 2% of your assets each year with a combination of advisory fees, loads, fund management fees, transaction fees, etc. Often these are well hidden and hard to see (we had an advisor for a while and he always talked about the advisory fee and how reasonable that was, but that was really just the tip of the iceberg). Over a 30 year investing lifetime, a 2% fee can take half your portfolio!

Who charges a 2% fee?

 

[latexman]

The bigger question is whether you really need a financial advisor. If you are using a fee-only advisory, that's great, but if the advisory relationship is typical, you are losing more than you might realize. Most firms are looking to take 2% of your assets each year with a combination of advisory fees, loads, fund management fees, transaction fees, etc. Often these are well hidden and hard to see (we had an advisor for a while and he always talked about the advisory fee and how reasonable that was, but that was really just the tip of the iceberg). Over a 30 year investing lifetime, a 2% fee can take half your portfolio!

Where did this come from? The OP didn't even hint at it.

 

[Sunset]

Who charges a 2% fee?

Chase.
That is what they charged my FIL to "manage" his tiny stock portfolio by putting him in around 30 stocks and funds , some of those funds also charged over .50%.

When he finally showed me, I moved him to Vanguard.

 

[Zorba]

It seem to me a conversion is a pay tax now or pay tax later question, while passing on highly appreciated mutual funds in the taxable account is a skip paying tax all together strategy? It seems the appreciated asset is a better strategy?
Am I missing something? What do you think?

I don't have a crystal ball, so I look at it like I looked at the last 30+ years during the accumulation phase. I want to diversify my risk.

I don't know if the step up basis will go away, or if income/cap. gains tax rates will increase in 2026, or if the tax-free status of Roths above some limit will go away, or <insert favorite tax proposal here>.

However, what I do know is that in light of these uncertainties, I want tax *diversification* during the decumulation phase. For me that means holding a reasonable mix of Taxable, Tax Deferred and Tax Free (Roth).

All the best.

 

[Exchme]

Where did this come from? The OP didn't even hint at it.

I read the phrase "my investment guys advice" as a hint that there is an investment advisor.

The point is that if the "investment guy" is an AUM advisor, OP may be focusing on the wrong thing, Roth's may or may not be a good idea depending on a lot of factors, some of which are essentially unknowable (future returns, life span, kids finances when they inherit, tax laws), but getting rid of an advisor is real money in the pocket.

In my case, I find that the math of paying the capital gains tax on the appreciated assets is a big hindrance to doing Roth Conversions as those are new lifetime taxes (once RMDs start, I have no need to sell taxable assets so they would get the step up basis on death), whereas taxes on the t-IRA are owed at some point, it's just a question of arbitraging the tax rate.

 

[VanWinkle]

Who charges a 2% fee?

AUM of 1.35% on first 250,000 at Eddie Jones along with possible AM Funds front loaded at 5.75% or back loaded at 1%. Don't kid yourself, 2% is a likely charge for many financial advisors/financial brokerages. High expense funds with 12b-1 fees of .25 to .75%. It all adds up fast.

Vw

 

[CincyDave]

Everyone's situation is different, but I plan to spend TIRA money first and leave regular accounts for the kids to take advantage of step up. If step up goes away, may rethink. Also fully funding HSA until Medicare and may do some roth conversions, depending on income. That's the plan at this point at least.

 

[CardsFan]

I don't have a crystal ball, so I look at it like I looked at the last 30+ years during the accumulation phase. I want to diversify my risk.

I don't know if the step up basis will go away, or if income/cap. gains tax rates will increase in 2026, or if the tax-free status of Roths above some limit will go away, or <insert favorite tax proposal here>.

However, what I do know is that in light of these uncertainties, I want tax *diversification* during the decumulation phase. For me that means holding a reasonable mix of Taxable, Tax Deferred and Tax Free (Roth).

All the best.

You need to stop being so darn practical, don't you know the sky is falling?

Seriously, you are spot on. That mix can come in handy to control income, for any variety of reasons (ACA, Roth conversions, lower taxes, etc)

 

[Exchme]

AUM of 1.35% on first 250,000 at Eddie Jones along with possible AM Funds front loaded at 5.75% or back loaded at 1%. Don't kid yourself, 2% is a likely charge for many financial advisors/financial brokerages. High expense funds with 12b-1 fees of .25 to .75%. It all adds up fast.

Vw

Yep, big chunks of the advisory business is 2+% when everything is added up. Our advisor charged 0.55% for advisory fees (originally it was 0.85% below $1M). Doesn't sound toooo bad? But that wasn't all - the funds charged 0.55% management fees and the funds bought pieces of other funds that charged another 0.60-0.90%, depending on which fund. You would only find all those fees if you read the fund prospectuses and of course nobody does that until too late, if ever.

Anyway, not to derail the thread too badly, if OP provides more details - rough amounts in different accounts, goals, possible heir's tax rates, etc. it might be possible for people with similar circumstances to weigh in with what they found - as it is, it's a bit vague.

 

[Safe Harbour]

Thanks All,

Some sage advice there. I especially found Zorba's thoughts on risk applicable. I do not have an AUM advisor. I have used Vanguard's low cost MF's and ETF's for my entire retirement since 2010. By Advisors, I meant my free advice from my Vanguard Flagship Team, a Fee Only advisor that answered this specific question for me, and my Tax guy. I also used Income Strategy dot com.

I find I have 5 more years until SS must start at age 70 so I could convert up to the top of my current 24% bracket. This should take my ROTH up from 7.5% of my total to 12% of total. I'll then have 37% tIRA, 49% Taxable, 12% ROTH, <2% Inherited IRA.

I think plan to spend all the fixed income in my taxable but leave the appreciated equities. Then spend my tIRA down as much as possible. Two kids will have higher taxes than I do in retirement and one lower. So maybe I should consider which kid inherits from which accounts?

What do you think of that. Also I am married.

I don't have a crystal ball, so I look at it like I looked at the last 30+ years during the accumulation phase. I want to diversify my risk.

I don't know if the step up basis will go away, or if income/cap. gains tax rates will increase in 2026, or if the tax-free status of Roths above some limit will go away, or <insert favorite tax proposal here>.

However, what I do know is that in light of these uncertainties, I want tax *diversification* during the decumulation phase. For me that means holding a reasonable mix of Taxable, Tax Deferred and Tax Free (Roth).

All the best.

 

[TheWizard]

I'm in the 24% Federal bracket as well and should mention that if you convert to the top of the 24% bracket, you will just cross over another IRMAA tier threshold, the $165k/person one.
So maybe convert up to get AGI/MAGI up to just under that threshold.

The whole business about how the new law with ten year depletion of inherited IRA is a bit of a quandary.
If paying taxes at a higher rate is going to be too much of a burden on the recipients, you could always donate 50% of your traditional IRA to charity, thus reducing the amount of tax burden to your heirs.

In fact, doing a $10,000/year charitable contribution using a QCD, starting now, will free up space for an additional $10,000 of Roth conversion before hitting your defined top.

But a lot of this strategy will depend on how financially secure the survivor in your marriage will be after the first passes...

 

[Sunset]

Everyone's situation is different, but I plan to spend TIRA money first and leave regular accounts for ...advantage of step up. If step up goes away, may rethink. ... and may do some roth conversions, depending on income. That's the plan at this point at least.

Same plan.

• Spend from IRA's , dividends and interest from taxable.
• Do some Roth conversions.
• Leave the capital gains to build in taxable for step up basis.

Another factor in this for us is, in IL money from IRA or retirement income is NOT taxed by the State.
Switching from creating capital gains to taking IRA money out has decreased our State taxes saving over $3K per year and slowing the increase in IRA (which will be RMD'd at a higher rate due to getting SS).