Roth conversions have been a hot topic in recent years. The relatively low federal income tax rates now in effect can make conversions less taxing.
Moreover, the SECURE Act’s requirement that most non-spousal beneficiaries must fully distribute their inherited IRAs within a 10-year time frame reduces the multi-generational appeal of pre-tax accounts, spurring Roth conversions. Another SECURE provision ended the opportunity to undo Roth conversions, so the best time to do them is late in the year, when precise planning is most likely.
All that said, one often overlooked factor is the state tax effect on Roth conversions. From our nationwide experience, the possible state tax implications are twofold: those regarding state income taxes as well as those regarding state estate or inheritance taxes. (This discussion covers Roth IRA conversions but the information here may apply to other types of Roth accounts.)
IMPACT OF INCOME TAXES
For income tax purposes, we group states into three categories: states with no income taxes, states with income taxes, and states with income taxes plus special rules. Those special rules can make a meaningful difference, especially if a client is thinking about moving to another state.
Say Ava is a Florida resident, facing no state income taxes. Her advisor needn’t be concerned about state tax on a Roth conversion if she has no relocation plans.
Or suppose that Ben lives in North Carolina and plans to stay there. He’ll face a 5.25% state income tax, regardless of when he converts his IRA to a Roth.
TEMPTING TAX BREAKS
However, there are 13 states with special rules for attracting retirees or enticing them to move there, including 12 with exclusions for IRA income. If clients either live in or are thinking of moving to one of these states, advisors should point out how Roth conversions will be affected.
For example, Carol lives in Pennsylvania, which has an unlimited exclusion for all retirement plan income, including IRA distributions, with no age limit. Carol may be well advised to execute her Roth conversion or partial conversions before any move to another state.
Not every state with special rules for retirement income is as generous as Pennsylvania. Some states place limits on the amount of IRA income they exclude from tax: limits may depend on the taxpayer’s age or the amount distributed or both.
For example, clients living in Mississippi have the same unlimited exclusion as Pennsylvania, but only if they are at least age 59-1/2. Some other states’ retirement income exclusions are based on the account owner’s birth year (Michigan) or the funding source for the IRA (Hawaii).
Advisors who learn about these varied special rules and how they work can show clients how to trim their state tax liability by planning when—and where—to execute Roth conversions.
(We have outlined each state’s special income tax provisions in this issue’s insert. In addition to the state tax data there, some cities and counties also have income taxes that should be considered when planning for Roth conversions.)
A MATTER OF TIMING
Sometimes our clients move from high-tax areas to states where there are no income taxes. For instance, Doug might be looking forward to moving in retirement from New York to Florida, to enjoy the sunshine. From a state income tax perspective, we’d suggest that Doug wait for a Roth conversion until after the move, because New York has steep income taxes and Florida has none.
We also have seen the reverse—Erin might move from an income tax friendly state to a state with higher taxes; say, trading in the east coast (Georgia) for the west coast (Oregon), only to find that Oregon’s income taxes are higher than Georgia’s.
In such a scenario, it might make sense for Erin to convert her traditional IRA to a Roth before moving to high-tax Oregon, paying lower state taxes in Georgia. Note that Georgia is one of those special-rule states we mentioned earlier, so such a decision would become even more compelling if Erin is 62 or older before moving and can utilize Georgia’s exclusion.
High-tax or low(er)-tax, all states like to get their piece of a resident’s pie, one way or another. We’ve revealed how most states get an income tax slice, but there are also state estate and inheritance taxes to consider.
Currently, there are twelve states (plus the District of Columbia) that impose estate taxes and six that impose inheritance taxes. Only Maryland has both.
The general framework for each state’s estate tax system is similar: there is an exemption amount and a graduated tax rate on any excess assets, which increases with the value of the taxable estate. State exemptions range from $1 million (Oregon and Massachusetts) to $5.85 million (New York) while the applicable tax rates range from 0.8% (Rhode Island and Maryland) to as high as 20% (Washington and Hawaii).
Clients who live in New York may enjoy your pointing out this fun item (or not!). The New York exemption acts more like a cliff than a gradual slope. If the taxable estate is less than the basic exclusion amount ($5.85 million in 2020), no New York estate tax is due. But if an estate of a New York resident exceeds that threshold by even $1, the estate tax rate applies, starting with the first dollar of estate value. There is an estate tax credit equal to the taxes incurred on the basic exclusion amount, but that credit is phased out once an estate exceeds $6.1425 million. Not simple, but vital for high-net-worth New Yorkers to know.
PAYABLE ON RECEIPT
State inheritance taxes also tend to follow a general framework. Taxation is based on the decedent’s state of residency, rather than the beneficiaries’ home states. Nevertheless, it’s the beneficiaries—not the deceased’s estate—who pay the tax.
Each state typically has a graduated tax rate that is based on either the “class” of beneficiary and/or the value of the property being inherited. If the beneficiary receiving the inherited property is in a certain class, or if the value of the property being transferred is under a specific threshold, the tax may be waived. Surviving spouse beneficiaries are exempt from all inheritance taxes and most states (except Nebraska and Pennsylvania) also exempt children.
Why are state estate and inheritance taxes relevant to Roth conversions? Because any federal or state income taxes imposed on the conversion are paid upfront, reducing the size of the overall estate.
For example, your client Frank lives in New York; he has an estate worth $6.2 million, including the value of his large traditional IRA. You might advise Frank to convert IRA money to a Roth and pay the income tax. Such a plan could bring Frank’s estate value under New York’s $5.85 million exemption amount, for considerable tax savings.
As another example, suppose your client Grace lives in Texas and plans to move to Washington. Neither state has an income tax but Washington, unlike Texas, has an estate tax. You might advise Grace to convert her traditional IRA to a Roth before or shortly after moving to Washington because failing to convert before death could potentially increase her future estate tax liability.
In some cases, Roth conversion strategies should consider state estate or inheritance taxes in conjunction with state income taxes. Say your client Henry lives in Florida and wants to move to Maryland to be closer to his family. Here, Henry would go from facing no state income, estate, or inheritance taxes to having to plan for all three!
Because you’re aware of the issues described above, you could begin mapping out Roth conversions to reduce this state tax triple threat. You might save Henry and his heirs substantial amounts of tax, demonstrating the value of sophisticated advice.
MORE PIECES TO THE PUZZLE
Some special situations can add an extra layer of complexity when advising clients about Roth conversions. They include:
- Atypical assets in a client’s IRA. Assets such as real estate or land require special attention because the rules for real property often depend on the state where the property is located rather than the client’s residency.
- Roth conversions during the year of an interstate move. After such conversion, clients could be required to file a part-year resident/non-resident tax return for both their previous and new states. Advisors might suggest converting in the calendar year before or after the year of moving, to simplify tax filing.
- Choosing which pocket to pick for paying Roth conversion taxes. Paying with non-IRA funds promotes more tax-free growth because the IRA won’t be depleted.
As financial professionals, we should consider every angle when forming client recommendations. Federal taxes may play the primary role in developing Roth conversion strategies but you can demonstrate the value you’re adding by showing the savings that result from your consideration of state income, estate, and inheritance taxes as well.
The current state tax rates are based on sources believed to be factual and reliable. The tax rates are subject to change based on changes to tax legislation in each state. The information provided is for informational purposes only and should not be construed as tax or legal opinion. Please consult a tax or financial advisor with questions about your specific situation.
Copyright © 2020, Smart Subscriptions, LLC Reprinted from Ed Slott’s IRA Advisor, December 2020, with permission. Smart Subscriptions, LLC takes no responsibility for the current accuracy of this article.