IRAs and Retirement Accounts

Unfortunately, one of my clients is entering the last stages of her life.  Her deductible medical expenses this year have been substantial due to home healthcare and hospice care.  I checked with her CPA and confirmed that a portion of her IRA can be converted to a Roth IRA for a modest income tax cost.  I talked to her brother, who has her power of attorney, and recommended that he convert a portion of the IRA to a Roth IRA. 

The conversion will eliminate future income taxes for my client’s children on future distributions from the Roth IRA.  The future savings for the children, one of whom lives in a state with a state income tax, will far exceed the incremental 2015 income taxes that my client will pay. 

An ancillary benefit is that my client has a taxable estate for federal estate tax purposes.  The incremental income taxes will be deductible for federal estate tax purposes (or will reduce her taxable estate if she unexpectedly lives beyond April 15).  This effectively reduces the incremental income taxes by 40%.  Assume for example, that $100,000 is converted at a tax cost of $15,000.  The net cost after factoring in the estate tax deduction of 40% will only be $9,000.  The future tax rate for my client’s children will far exceed 9%. Thus the overall taxes will be reduced. 

In summary, a late-in-life Roth IRA conversion may save substantial income taxes for your children.  Make sure that you have a durable general power of attorney which authorizes your agent to make a Roth IRA conversion.

When an IRA account owner dies, his or her designated beneficiary can choose to withdraw the account or maintain the IRA as an “Inherited IRA.”  Numerous beneficiaries of Inherited IRAs have declared bankruptcy and claimed that the Inherited IRA was exempt from attachment by the creditors.  Some Circuit Courts of Appeal had held that inherited IRAs are exempt funds in a bankruptcy setting.  Other Circuits had ruled to the contrary. 

The Supreme Court has resolved the conflict by ruling that inherited IRAs are not exempt for bankruptcy purposes.  The court’s rationale was that the purpose of the bankruptcy exemption for retirement funds is to protect the money for the person who earned the money.  The exemption was not meant to protect heirs of the person who earned the money.

Some states have exempted Inherited IRAs from bankruptcy.  Depending on where the beneficiary of the Inherited IRA lives, he or she may be able to use the state exemption and not be affected by the Supreme Court ruling. 

The practical effect of the ruling for debtors living in the wrong states is to make Inherited IRAs the same as any other account owned in the debtor’s name.  The account will not be protected if the debtor declares bankruptcy. 

In light of this ruling, surviving spouses should consider segregating an IRA that they inherit from their spouse in a separate account.  The law allows you to combine your spouse’s IRA with your own IRA; however, that may bring into question the creditor protection benefits of your own IRA.  Further, if you maintain separate accounts, you should make withdrawals from the Inherited IRA rather than your own IRA.

When designating the beneficiary of your own IRA, you should consider establishing a trust as the beneficiary.  A properly drafted trust will give your beneficiary the flexibility to withdraw the funds over several years without exposing the funds to the beneficiary’s creditors.

Despite the Supreme Court’s ruling, you can still achieve creditor protection for the portion of your IRA that you pass on to your beneficiaries.  However, the process to obtain the creditor protection has become more complicated.  

In a recent case, Cajun Industries, LLC vs. Robert Kidder, et al., the decedent designated his three children as beneficiaries of his 401(k) plan after his first wife died. He remarried a few months before he died and did not realize he needed to make any changes because he still wanted his 401(k) plan to go to his children. Unfortunately, when he died, his new wife successfully claimed the entire 401(k) account due to a federal law known as ERISA. This law required Mr. Kidder to fill out a new beneficiary form after he remarried and to obtain the consent of his new wife.  Because his wife had not consented to his designation in favor of his children, ERISA required the account to be distributed to his wife.

There were two other potential solutions that would have allowed the funds in the 401(k) account to go to Mr. Kidder’s children. Prior to getting married, Mr. Kidder could have asked his wife to sign a prenuptial agreement wherein she agreed to sign a waiver of his 401(k) plan. Alternatively, before he married, Mr. Kidder could have rolled his 401(k) account to an IRA and then designated his children as beneficiaries of his IRA. The rules requiring a spousal waiver to a beneficiary designation do not apply to IRAs.

A previous article explained that IRA account holders who did not make a charitable distribution in the last two weeks of 2010 can make a $200,000 Charitable IRA Distribution in 2011, provided that at least $100,000 of the distribution is made by January 31, 2010. One of my clients asked whether there is any way for him to convert his 2010 required minimum distribution (“RMD”) into a charitable distribution.

My client took his RMD of $82,000 on December 1st prior to going to Florida for the winter. He would now like to give the $82,000 to charity so that he does not have to pay tax on the RMD. Unfortunately, there is no way for him to avoid paying income tax on the RMD.

He can make an $82,000 distribution from his IRA to charity in January, 2011. If he had not taken the RMD in 2010, he could treat the January distribution made to charity as a non-taxable RMD for 2010. However, since he already received the $82,000 as a taxable RMD, the January gift will not help him to reduce his 2010 income taxes.

Over the past 6 trading days, the Dow Jones Industrial Average has dropped from 11,167 to 10,380, which is a drop of 7.6%. If you have not already converted your IRA to a Roth IRA, this is a golden opportunity to make the conversion.  By converting now, you might lose the opportunity to convert at the bottom if the market drops further. However, if it turns out that this is merely a temporary correction, you will be glad you made the conversion even if you slightly miss the bottom. If this turns out to be the beginning of a bear market, you can recharacterize your Roth IRA to a traditional IRA and try again next year. The recharacterization option lets you “win” if the market rebounds and “break even” if the market goes down further.

A market correction is also a good opportunity for establishing a GRAT. GRATs are similar to Roth IRAs in terms of letting you start over without a penalty if the market declines after you establish the GRAT. This may be your last chance to make a tax-free transfer of wealth to younger generations through the utilization of short-term GRATs. Congress is considering legislation that would eliminate this opportunity.  

For the last four years, IRA owners who are over age 70.5 have been able to make charitable gifts from their IRA of up to $100,000 per year. This law has been extended before and Congress is currently working on another extension for 2010. Congress’ willingness to continue extending this law is attributable to the popularity of this technique.

Even if Congress extends the law, there may be a better way to make a gift to charity. Here’s how it works: Step 1: Determine how much you want to give to charity from your IRA. Step 2: Make the gift to charity from your non-IRA assets. For example, you could give highly appreciated securities or real estate. Step 3: Convert the same amount of your IRA to a Roth IRA.

The income from the Roth conversion will be offset by the charitable income tax deduction so that the net effect on your income taxes is neutral. Income tax neutrality is consistent with a direct gift to charity from your IRA. However, the synthetic gift has the additional effect of converting appreciated securities from your taxable portfolio into a Roth IRA where you will never pay taxes on the appreciation or the earnings of the securities.

There are 3 other benefits of the synthetic gift technique. You are not limited to a charitable gift of $100,000 per year. You can make a gift to your private foundation or donor advised fund. This is not possible with a direct gift from the IRA.  Finally, if you have not yet attained age 70.5, you are not eligible to make a direct gift from your IRA.  The synthetic gift technique has no age limit.

There is a potential pitfall with this technique. There are complicated income tax rules that affect the timing and amount of your charitable income tax deductions. Make sure your CPA examines the consequences before you make a synthetic charitable IRA gift™.

A synthetic charitable IRA gift™ may be a better choice for you than a charitable IRA rollover because it provides money to charity and allows you to convert a portion of your taxable portfolio to a Roth IRA. 

A prior article pointed out that higher tax rates in the future would increase the chance that converting your IRA to a Roth IRA would provide a benefit to you and your family. We now know that income tax rates for high-income individuals will increase beginning in 2013, due to the 2010 Healthcare Act.

High-income taxpayers, defined as single people earning more than $200,000 and married couples earning more than $250,000, will be hit with a a tax increase on wages and a new levy on investments. Under the provisions of the new law, which take effect in 2013, high-income taxpayers will be taxed at an additional 0.9% on wages exceeding $200,000 for single people or $250,000 for married couples.

Beginning in 2013, a new 3.8% tax will be imposed on net investment income of high-income taxpayers. Net investment income includes interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allocable deductions to such income. However, the new tax will not apply to income in tax-deferred retirement accounts such as IRAs and 401(k) plans. Also, the new tax will apply only to income in excess of the $200,000/$250,000 thresholds.

These new taxes enhance the benefits of a Roth IRA conversion in two respects. First, if you do not make the conversion, the required distribution from your regular IRA will increase the chance that you are a high-income individual. Even though the new investment tax will not apply to the amount distributed from a regular IRA, the income from the IRA may force more of your other income to bear a 3.8% tax. If you had converted to a Roth IRA, you would not be required to take a required minimum distribution. Even if you take a distribution, it would not be considered income.

If you make a Roth IRA conversion, it is advisable to pay the income taxes from separate assets. If you do not make a conversion, the income from those separate assets would be hit with this 3.8% investment tax. Stately differently, the after-tax income that you would have received from the money used to pay the conversion tax will be decreased due to the new 3.8% investment tax.

The increased taxes for high-income taxpayers may only be getting started. The new taxes in the Healthcare Act help to pay for the benefits provided by the Act. Many have predicted that the cost of the new Act will substantially exceed the government’s estimates. If this is true, someone will have to pay for the additional costs.

Regardless of whether the new taxes fully pay for the Healthcare Act, someone needs to pay for the burgeoning federal deficit. High-income taxpayers will be a likely target. Any additional taxes imposed in the future will further enhance the benefit of having made a Roth IRA conversion in 2010.

This is the eighth and final article of a series dealing with the topic of converting your traditional IRA to a Roth IRA. For prior 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 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving

Roth IRAs  are tremendous assets to own because they grow tax-free, allow tax-free withdrawals, and do not require you or your spouse to make withdrawals.

Determining whether the cost of a Roth IRA is a good investment depends on numerous factors, including income tax rates that will apply to you and your family now and in the future, whether you and your family can pay the conversion tax and meet your spending needs from other sources, whether you will be subject to estate taxes, and how much you plan to give to charity during your lifetime and at death.

Wealthy families are the most likely candidates to benefit from a Roth IRA conversion because they are likely to be in a high income tax bracket in the future, they can pay the conversion tax and meet spending needs from other sources, they will be subject to estate taxes, and they are able to make additional charitable gifts to offset the income tax generated by the conversion. 

The recharacterization option is a valuable tool which allows you to make a conversion and then change your mind as long as 21 months later. During this 21-month period, you will see tax law changes that have occurred and how your investments have performed. When you make a conversion, you should create several Roth IRA accounts, with each account holding different asset classes, in order to maximize the flexibility afforded by the recharacterization option.

Most wealthy individuals should make a conversion and follow the steps outlined in the following timeline.


2 Year Timeline for Roth IRA Conversions


February 2010 Convert now by creating several Roth IRA accounts that hold different assets.
December 2, 2010 Recharacterize Roth IRA accounts that have decreased in value.
December 15, 2010 Determine whether you want to make additional charitable contributions to offset income from conversion.
January 2, 2011 Reconvert accounts that were recharacterized on December 2, 2010 by creating several Roth IRA accounts.
April 15, 2011 Determine the maximum amount of the 2010 conversion that you might not recharacterize (i.e., leave as a Roth) and whether you might treat the income as taxable for 2010 (instead of deferring 50% to 2011 and 50% to 2012). If you might tax the income in 2010, file an extension for filing your 2010 federal income tax return and pay estimated taxes based on the maximum amount that you might treat as income in 2010.
October 15, 2011 Final day for recharacterizing 2010 conversions. If you extended the filing date for your 2010 federal income tax return, you must file your return and elect whether to recognize the income from 2010 conversions in 2010, or in 2011 (50%) and 2012 (50%).
December 2, 2011 Recharacterize 2011 Roth IRA conversions, if any, that have decreased in value.
December 15, 2011 Determine whether you want to make additional charitable contributions to offset income from 2011 conversions and 2010 conversions that were deferred.


This is the seventh article in a series of eight articles 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 6 – The Impact of Estate Taxes
Part 8 – Putting It All Together

Individuals who make significant charitable gifts have additional considerations when evaluating whether to convert a traditional IRA to a Roth IRA. A lot of my clients plan to give at least a portion of their traditional IRA to charity upon their death. In addition to wanting to make charitable gifts, these clients realize that the bequest to charity will avoid income taxes and estate taxes. Individual beneficiaries would have to pay income taxes if they received the IRA. Furthermore, if the IRA owner’s estate is larger than the allowable estate tax exemptions, there will also be estate taxes imposed upon the portion of the IRA that is paid to children.

Individuals who plan to give their IRA to charity have less to gain by making a conversion. If you are planning to leave a portion of your IRA to charity, a conversion will cause you to pay income taxes now that you might not otherwise be paying later. In certain circumstances, you can still justify making the Roth IRA conversion. Nevertheless, I have discouraged my clients who plan to leave their entire IRA to charity from making the Roth conversion.

Some IRA owners intend to leave only a portion of their IRA to charity. Assume that Mrs. Brown has a $500,000 IRA and the beneficiaries are designated as follows: $100,000 to XYZ Church, $100,000 to XYZ University, and the balance to children.

Mrs. Brown can convert a portion of the IRA to a Roth IRA. Ideally, she will not convert beyond the amount which will allow there to be at least $200,000 in her traditional IRA upon her death. Some guesswork will be required to determine how much to leave in the traditional IRA so that there is at least $200,000 at the time of her death because there will be earnings and required minimum distributions during her remaining lifetime.

Assume that Mrs. Brown expects to live to age 90 and her investment advisors recommend that she leave at least $300,000 in her traditional IRA so that there will be at least $200,000 left when she dies. She should convert the entire $500,000 and place $100,000 in five separate accounts. No later than October 15 of the year following the conversion, she will recharacterize three of the accounts, or perhaps more if investments have performed poorly. This technique allows her to make the conversion with the best performing accounts while leaving sufficient funds in the traditional IRA to make the charitable bequests at the time of her death.

Your lifetime charitable giving is also relevant to the Roth conversion analysis. You will recognize income in the year of the conversion. For conversions in the year 2010, you can elect to recognize 50% of the income in the year 2011 and 50% in the year 2012. If you know that you will be making large charitable gifts in the future, you may choose to accelerate those gifts into the year of the conversion (or into 2011 and 2012 for conversions in the year 2010).

If you need a charitable deduction now, but do not want the charities to receive the funds until later, your charitable donation can be “escrowed” in a donor advised fund or a private foundation. Both of these structures allow you to identify the charitable recipients and make the actual charitable gifts in a later year.

In summary, you should consider accelerating charitable gifts to reduce income taxes attributable to a conversion of your traditional IRA to a Roth IRA. You should not convert the portion of your traditional IRA that you intend to leave to charity upon your death.

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.