Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

This is the fourth article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

If you convert to a Roth IRA, you are betting that the present value of incremental withdrawals by you and your family in the future are greater than the taxes you will pay at the time of the conversion. Future withdrawals will be maximized when you and your heirs keep the Roth IRA intact for a long time.

The first and most important hurdle for keeping the Roth IRA intact is whether you can pay the tax on the conversion from other assets. If you must use funds from the IRA to pay the tax, my advice is to not make the conversion.

The next hurdle is whether you and your spouse will need to take withdrawals from the Roth IRA. One benefit of Roth IRAs is that you do not have to take required minimum distributions during your lifetime. If you designate your spouse as the beneficiary following your death, your spouse can rollover the Roth IRA to his or her own Roth IRA. Your spouse will not have to take any distributions during his or her lifetime. Thus, if you and your spouse can meet your living expenses from other sources, you will never have to take a distribution during your remaining lifetimes.

The final hurdle is the time period over which your children (and/or grandchildren) will take withdrawals from the Roth IRA after you and your spouse die. They will be required to take distributions over their remaining life expectancy, determined under IRS tables at the death of the survivor of you and your spouse. For example, if the beneficiary is age 45, his or her life expectancy is 38 years.

Your beneficiaries will be eligible to leave the Roth IRA intact for a long time. However, imagine the temptation for the beneficiaries to make tax-free withdrawals to buy new cars or to take vacations. If you are concerned that your beneficiaries might take distributions for wants rather than needs, you can use a trust as the beneficiary of the Roth IRA. The Trustee would be required to withdraw the required minimum distribution and could withdraw more if the beneficiary needs more. In addition to slowing down withdrawals, the Trustee might add investment expertise that the beneficiaries lack.

Families that can meet spending needs from sources other than the Roth IRA have more to gain from converting a traditional IRA to a Roth IRA. If the Roth IRA will be liquidated relatively quickly, paying tax now is less likely to provide a benefit to your family.
 

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It now appears very likely that we will begin the new year with no Federal estate tax in place. A law passed in 2001 repealed Federal estate taxes for the year 2010. That same law provided that the estate tax would reappear in the year 2011 with a $1 million exemption amount and a top rate of 55%.

Congress has known about this anomaly for the last 8 years. There has been universal agreement that the law needed to be amended in some fashion. Nevertheless, the law has not been changed because Congress could never agree on how to change it.

One group of legislators wants to permanently repeal estate taxes. Another group wants to retain estate taxes with a higher exemption amount than $1 million. It is widely predicted that Congress will address this issue early in 2010 and perhaps reinstate estate taxes effective as of January 1, 2010. An attempt to enact a retroactive tax might be a violation of the United States Constitution. There is some precedent suggesting that a retroactive tax would be allowed if enacted.

There is another significant issue for persons dying in 2010. Assets will no longer receive a basis equal to the date of death value of the assets, which is current law. Instead there will be a "carryover basis" regime, with the ability to obtain a "step-up" in basis for a limited amount of assets. A similar regime was briefly enacted in the 1970s, and was repealed almost immediately because it was so impractical. It is very difficult to establish the historical basis of inherited assets. Additionally, heirs of many estates that would not have been required to pay Federal estate tax under current law will now have to pay capital gains taxes when they sell inherited assets.

Planning your estate amidst this uncertainty is challenging. You need to be prepared for the law that is on the books, i.e., a federal exemption of only $1 million per person in future years. You also need to make sure that your Will will work in the manner intended if you die during the year 2010. In particular, you need to review any formulas in your Will that are based on an estate tax system that may not exist at the time of your death.

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The father of one of my clients is considering a move to Nashville in order to be closer to his daughter and grandchildren. He called me regarding the state tax consequences of moving to Tennessee.

The good news is that his income taxes will decrease slightly because Tennessee will not tax his IRA distributions. He will pay the Hall income tax on his dividends and interest, but he is already paying taxes on that income in the state where he currently lives.

The bad news is that Tennessee inheritance tax will apply to his estate when he dies. He currently lives in one of the many states that does not have a state inheritance tax. Based on his estate of $3.5 million, his Tennessee inheritance tax bill will be approximately $225,000.

Inheritance taxes would be much higher if his estate has to pay inheritance tax on the $6 million marital trust that his wife established upon her death. The marital trust will be taxable for federal estate tax purposes. However, Tennessee does not tax marital trusts that were established by residents of other states. Since the Tennessee inheritance tax rate is 9.5%, not having to pay Tennessee tax on the marital trust will reduce his estate’s Tennessee inheritance tax bill by $570,000. He told me that this tax reduction is good enough to allow him to move to Tennessee.  If the marital trust would be subject to Tennessee inheritance tax, he probably would not move.

The planning opportunity is to have a marital trust established for your benefit prior to moving to Tennessee. If you know friends or family members such as parents who are considering a move to Tennessee, encourage them to establish and fund a marital trust prior to moving to Tennessee. For example, a husband might establish a marital trust for his wife prior to moving. The marital trust will not escape federal taxes; however, it will escape Tennessee inheritance taxes because it was established by a non-resident of Tennessee.
 

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Yesterday, I met with a spry 90 year old widow who believed that her Will gave $1 million to her grandchildren. I determined that her will actually gives $3.5 million to her grandchildren. If she had died with this Will, her grandchildren would have received significantly more than her two sons.

The reason for my client’s misunderstanding was her Will’s use of a formula. The bequest to the grandchildren was an amount equal to her “available GST exemption”. When her Will was drafted, her "available GST exemption" was $1 million. However, due to law changes that have occurred over the last several years, her GST exemption increased to $3.5 million.

It is very common for Wills to contain formulas that are based upon tax laws. This allows your Will to take advantage of changing exemption amounts without having to redraft your Will every time there is a law change. However, when a Will uses a formula, your attorney should explain the effect of the formula. I suspect that my client’s former attorney did explain the formula. Nevertheless, all she remembered was that the formula resulted in a bequest of $1 million.

There are a lot of formulas that are going to be distorted if Congress does not amend the estate tax laws within the next three weeks. As the law is currently written, there will be no federal estate taxes in the calendar year 2010. Because a lot of formulas are written based upon laws that simply will not exist for people dying in 2010, numerous formulas will not make any sense. Other formulas will be open for debate. As an example, I believe that my client’s Will will result in a bequest of $0 to her grandchildren, because it refers to an exemption amount that will simply not exist in 2010. The grandchildren might challenge that result as not representing their grandmother’s intent. I predict that there will be multiple lawsuits regarding these types of results if Congress does not change the law for 2010.

Tax-driven formula provisions in Wills are widely used and serve a useful purpose. Make sure you know what your formula means, and recalculate the results of your formula from time to time. If Congress does not change the tax laws in the next three weeks, everybody needs to check their formulas.
 

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The Congressional Research Service (“CRS”) has issued a report titled “Estate and Gift Taxes: Economic Issues.” The CRS is a “think tank” that provides reports to members of Congress on a variety of topics. Taxpayers spend over $80 million per year to fund the CRS. One controversial conclusion of the report is that

“…Only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small portion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.”

This report is supposedly based upon data from estate tax returns that have been filed. However, the conclusions drawn in the report are not realistic.

A lot of my clients have farms and small businesses. These clients worry a great deal about estate taxes. They purchase large life insurance policies to provide funds to be used to pay taxes. They establish and fund irrevocable trusts and various entities including limited liability companies and/or limited partnerships. They make gifts and sales to trusts for their children sooner than they would prefer if there were no estate taxes.

As mentioned in the report, some families are able to accumulate enough liquidity outside the business to pay taxes. In some cases, this means that the only asset left to pass on to children is the family business. When one or more children do not work in the business and cannot draw a salary from the business, this is not a happy result.

Perhaps my view is distorted because of the region in which I practice. Middle Tennessee probably has more valuable farmland than other areas of the country. The value is not necessarily based on the value of the land for farming. In many cases, the value of the farmland is artificially inflated by the development potential of the property.

Middle Tennessee also has a keen entrepreneurial spirit. I am constantly amazed by the ingenuity of my clients and how they have amassed a fortune from one or more business opportunities.

Nevertheless, the notion that reducing taxes on family businesses is not worthwhile clearly misses the mark. Owners of farms and successful family businesses spend a lot of time and money on planning strategies to cope with the liquidity crunch and distortions to their estate plan that are caused by estate taxes.

Members of the House of Representatives were not fooled by the Report. They understand that estate taxes create severe problems for owners of farms and family businesses. On December 3, 2009, they passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. Though this bill does not eliminate estate taxes, it seeks to ensure that married couples will be able to leave up to $7 million to their children without paying federal estate taxes. This bill has been forwarded to the Senate, where it faces an uncertain fate.
 

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This is the third article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. This article will examine the impact of income tax rates. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

A comparison of the income tax rate that will apply at the time of the conversion and the income tax rates that would apply to future withdrawals from your traditional IRA is the most important factor in helping you decide whether or not to make the conversion. The general rule is easy to state. If you anticipate your future income tax rates to be lower, converting to a Roth IRA is likely to be a poor choice. If rates will be the same or higher, converting is likely to be a good idea.

Judging by historical standards, the current top marginal income tax rate in the U.S. is extremely low. Since 1932, there have only been five years (1988-1992) where the top rate was lower than it has been for the period of 2003 through 2009.

 In light of the huge deficits that this country is facing, it seems inevitable that the highest marginal income tax rate will increase significantly. The top marginal income tax rate is currently scheduled to increase from 35% to 39.6% in 2011. The health care legislation that is currently being considered by Congress may include a surtax on the highest income taxpayers. We cannot tell for sure where rates are headed. However, there is a good chance that the highest rates will be increasing.

Not all wealthy individuals pay tax at the highest income tax rate. They may receive a lot of their income as tax-free interest on municipal bonds and tax-advantaged capital gains. Even if you are currently in the highest marginal income bracket, your income might decline in future years, especially if you are still working.

You need to keep in mind who will be paying the tax. It is reasonable for wealthy individuals to conclude that they and their spouses will always be in the highest marginal income tax bracket. However, if they only withdraw the required minimums, there will be a lot left in the IRA for their children. The children may not be in the top income tax bracket.

State income taxes should be considered. Tennessee does not impose an income tax on withdrawals from a traditional IRA. You might move to a state that imposes tax on distributions from a traditional IRA. It is more likely that your children will live in a state that imposes a tax on distributions from a traditional IRA.

You should also consider the possibility of leaving at least a portion of your traditional IRA to charity. If you are planning to make a bequest to charity upon your death, you should satisfy the bequest with a portion of your IRA. The income tax rate on distributions to charity from your IRA will be zero.

Even if income tax rates are highest in future years, this does not necessarily mean that you will benefit by converting. The conversion will likely force you into the highest bracket in 2010 because you will have the include the entire amount in your income for that year (or half in 2011 and half in 2012 if you make a deferral election).

The danger of higher income tax rates in the future will motivate a lot of people to convert at least a portion of their traditional IRA to a Roth IRA in 2010. Before you convert, you should consult with your CPA and other advisors to make sure that you are taking into account the myriad of factors that will determine the tax rates for you and your family if you do not make the conversion.
 

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This is the second article in a multi-part series dealing with the topic of converting a traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

This article will focus on recharacterizations. A recharacterization allows you to change your mind and undue a Roth conversion. This is such a valuable option, that it will significantly influence how many people choose to make a conversion.

A recharacterization can be made any time before October 16 of the calendar year following the conversion. This means that if you make the Roth conversion in January of 2010, you can recharacterize as late as October 15, 2011. You have nothing to lose by making the conversion in 2010. You can make the conversion, evaluate the consequences for up to 21 months, and then recharacterize if you decide that the conversion was a bad idea.

A decline in the value of the Roth IRA after the conversion will be a common reason for making a recharacterization. Alternatively, you might decide that you cannot afford to pay the tax from separate assets or that you or your children will be in a lower tax bracket in the future.

If you recharacterize, you must recharacterize the entire Roth IRA account. However, you do not have to recharacterize all Roth IRA accounts. If you segregate your IRA into multiple Roth IRAs at the time of the conversion, you will be able to pick and choose which accounts you recharacterize. If one or more of the accounts goes down in value, you may be well advised to recharacterize the accounts that have declined in value. You should work with your investment advisors to fund the various accounts with different assets whose historical returns have not been highly correlated.

If you only plan to convert a portion of your IRA, you might as well convert the entire account and create several Roth IRAs. You can then recharacterize the accounts that have the lowest investment return.

After you recharacterize, you can reconvert to a Roth IRA again. The reconversion can be made on the later of (a) 30 days after the recharacterization; or (b) the taxable year following the taxable year of the original conversion. For example, if you convert in January of 2010 and recharacterize on November 1, 2010, you will have to wait until January 1, 2011 before you can reconvert. If you recharacterize a January 2010 conversion on October 15, 2011, you will be able to reconvert on November 15, 2011.

Because the deadline for recharacterizing is October 15 of the year following the year of the conversion, there is an advantage to making a conversion in the early portion of the year. If you convert in December, you will have 10 months to decide whether or not to recharacterize. If you convert in January, you will have as much as 21 months to evaluate the decision.

In summary, the ability to recharacterize a Roth IRA conversion will cause numerous individuals to “test the waters” even if they are not convinced that the conversion is a good idea for them. When you convert your traditional IRA to a Roth IRA, you should consider splitting the IRA into several Roth IRAs so that you can maximize the benefits afforded by the recharacterization option.

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