In 2010, income limits to allow conversion of traditional IRA assets to Roth IRA were eliminated. This opened up the floodgates of financial planning ideas. The Roth conversion became a popular tool for retirement and tax planning. Less noted, a Roth conversion can be a powerful tool for estate planning.
Generally, a Roth conversion for estate planning is strategy most suited to those with a high net worth. Typically the strategy would entail converting an IRA to a Roth with the intention of not touching any of the converted Roth money, eventually passing it on to heirs.
As an example, let’s say you are married and have a net worth of $20 million. You have $4 million in a rollover traditional IRA that you can convert. If you do nothing, and you and your spouse both die in 2015, you each have an estate tax exclusion of $5,340,000. Based on the current portability laws, the second to die can use both exclusions. This means that $10,680,000 would pass estate tax free. Based on a current estate tax rate of 40%, your estate would owe $3,728,000 in estate taxes. By completing a Roth conversion prior to death would reduce your estate, thus reducing future estate taxes (more detail below).
Of course, as with any strategy, there are pros and cons:
- Taxes paid for conversion are removed from taxable estate. In the example above, if the Roth conversion resulted in income taxes of $1,800,000 (45%), your estate would be reduced by the full $1,800,000, reducing the estate taxes by $720,000.
- Beneficiaries receive non-taxable Roth IRAs instead of taxable IRAs, the latter of which would possibly cause them to get bumped into higher tax brackets. Non-spousal inherited IRA recipients are required to begin taking taxable distributions beginning in the year after the IRA owner’s death. The distributions from Roth IRAs are free of income tax, while distributions from traditional IRAs are added to the beneficiary’s income for tax purposes.
- Is there a year in which your capital gains/investment income is low? This may be the year to do the conversion, as it will certainly cause gains/investment income to be taxed at highest possible rate, including 3.8% medicare surtax. Income from IRA distributions (or Roth conversions) is not subject to the 3.8% Net Investment Income tax (aka medicare surtax), however, the income can push you over the limit causing all other investment income to become subject to the extra tax. If there is a year in which your investment income is low, this would be the best time to complete a large Roth conversion.
- You might consider investment allocation for Roth IRAs to be aggressive, since the investment time horizon is really for the next generation. Most retirees are not comfortable with the volatility of a portfolio with an aggressive allocation. Since the Roth conversion is effectively earmarked as assets to be passed on to heirs, the true time horizon before those funds are used is much longer than if you were planning to spend it during your retirement.
- Distributions are required from traditional IRAs, known as Required Minimum Distributions (RMD) beginning at age 70 ½. Roth IRAs do not have any required distributions. Removal of the RMD might reduce future tax liability, or make tax planning more beneficial, including the possible avoidance of the Medicare surtax in future tax years. The RMD from a large traditional IRA can push you into a higher tax bracket, causing not only the RMD amount to be taxed at a high rate, but other income as well. Converting your IRA eliminates future RMDs, or reduces it in the case of a partial conversion.
- Big, huge up front tax – generating liquidity to pay tax may cause further taxes. It has already been stated that the tax due in the example above would be $1,800,000 (at a 45% combined fed/state). That’s a really big pill to swallow. It might save both income and estate taxes long term, but you should really sit down with a Certified Financial Planner Professional and a tax advisor to run through some numbers.
- If beneficiaries are in a lower tax bracket, you are paying a large tax at a high rate in order to allow beneficiaries to avoid income at a lower tax rate. Obviously, that’s not a good strategy. However, the reduction of estate taxes might still make it a beneficial strategy.
- Ultimately, it is impossible to calculate the potential tax savings. There are simply too many variables, such as: your current and future income (and how much of it is ordinary vs. investment), the size of your estate, future growth rates of IRA assets, future growth rates of other assets (such as real estate or business ownership), beneficiary income levels (not just now, but well into the future), and the biggest unpredictable variable: future tax rates and methodology.
- If you are plan to leave a significant portion of estate to charity, traditional IRA assets should be designated for those bequests rather than converted during your lifetime. The traditional IRA assets that designate a qualified charity as the beneficiary reduce the taxable estate as well as avoid income tax on the amount donated. If a significant charitable contribution upon death is desired, the amount of the donation should remain in a traditional IRA.
- Future tax law changes could reduce or eliminate the value of the Roth IRA. I find it doubtful that congress will completely pull the rug out from under Roth IRA owners and deem distributions taxable, however, if they implement a consumption tax or VAT, the money is effectively taxed upon use. Of course, so would the IRA money. This only becomes a real issue if income taxes are reduced or eliminated by the implementation of a consumption tax or VAT. Additionally, other changes could reduce the income tax benefit of Roth IRAs. For example, a law could be passed in which Roth IRA distributions are not taxed, per se, but they are included in AGI, raising the threshold for other deductions, such as medical expenses. Or Roth IRA distributions might be included in the calculation to subject your investment income to the 3.8% Medicare surtax.
If you have a desire to reduce your future estate’s exposure to estate taxes, and also have a large amount of assets in traditional IRAs, executing a large Roth conversion is a strategy worth considering. However, you should consult with your financial and tax advisor first.