This is the sixth 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 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 7 – Ramifications of Charitable Giving
Part 8 – Putting It All Together
Wealthy individuals who expect to leave a significant portion of their IRA to their children or grandchildren have an additional reason to consider a Roth IRA conversion. The income taxes payable on the conversion will reduce the amount that is subject to estate taxes upon the death of the IRA owner.
The benefit can be illustrated by examining a “deathbed” conversion to a Roth IRA. Assume that a widow has a $5.5 million estate, including a $1 million traditional IRA, that she plans to leave to her children during a year when the federal estate tax exemption is $3.5 million. If a Roth conversion is made immediately prior to death and the widow is in the highest current marginal income tax bracket, herr estate would have to pay $350,000 of income taxes. However, the combined Tennessee and federal death taxes will decrease by approximately $176,000 because the income tax liability becomes an estate tax deduction.
Another way of analyzing the conversion is that the income tax rate on the conversion is 17.4% rather than 35%. Because the income tax rate is lower, the conversion is more likely to be a good idea.
Even though the effective tax rate on the conversion is only 17.4%, this does not guarantee that the conversion will be beneficial. The answer depends on the tax rates that would apply to future distributions to the beneficiaries of the IRA if you had not converted it to a Roth IRA.
Your beneficiaries will get future income tax deductions attributable to the federal (but not Tennessee) death taxes paid with respect to the IRA. This deduction will reduce income taxes on future distributions from the IRA to the beneficiaries. The value of this deduction will never be as good as the $176,000 reduction in estate taxes. Furthermore, federal tax law already imposes hurdles to getting the full benefit of this deduction. I predict that future tax laws will impose additional hurdles.
When calculating the income tax rate that will apply to your beneficiaries, keep in mind that they will also be receiving income from other assets that they inherit from you. The beneficiaries may also live in states that impose state income taxes on distributions from a traditional IRA (unlike Tennessee).
What if you die at a time when there is no federal estate tax? Assume that you convert in January of 2010, then die in December of 2010, and that the current federal estate tax laws are not revised. Your estate will not be subject to federal estate taxes. If you were counting on a reduction in federal estate taxes to make the conversion a good idea, your executor will be able to recharacterize the Roth IRA as a traditional IRA until October 15, 2011. I recommend discussing this matter with your executor and/or adding a codicil to your will.
IRA owners whose estates will pay federal estate taxes when they die can leave their children and grandchildren a more useful inheritance by converting at least a portion of their IRA to a Roth IRA. In most cases, the beneficiaries will receive more spendable after-tax income from their inheritance.