Press Room: Tax Release

January 12, 2011

IRA Conversions as Part of Your Estate Plan

The 2010 Tax Relief Act President Obama signed into law in December, 2010 contains several provisions that will have a significant impact on both income and estate tax planning. In keeping income tax rates at their current levels for the next two years, the Act makes converting traditional IRAs and other retirement accounts into Roth IRAs as attractive as ever. You may have seen some of the recent news articles about the possible income tax implications of converting your retirement account to a Roth IRA. What these articles rarely mention is the amazing estate planning opportunity that conversions can provide.

For taxpayers with significant non-IRA assets who do not expect to need their IRAs to fund retirement, converting an IRA to a Roth IRA can provide for tax-free compounding of the account assets over the lifespan of children, grandchildren or even great-grandchildren. The potential benefit of leaving a Roth IRA to a younger generation that will allow for continued tax-free growth over a significant number of years is compelling.

A few of the features of Roth IRAs, as compared to traditional IRAs, that make them so attractive from an estate-planning standpoint are: 

  • Unlike traditional IRAs, Roth IRAs are not subject to the required minimum distribution rules during the owner’s lifetime. This allows earnings of the IRA to continue growing over the owner’s life without being subject to income taxes.
  • As with traditional IRAs, heirs inheriting Roth IRAs must take annual minimum distributions from the accounts over their life expectancies. With Roth IRAs; however, these distributions are income tax-free.
  • The beneficiary of a Roth IRA can be a trust for an entire generation of descendents. While the Roth IRA will have to make distributions to the trust based on the age of the oldest beneficiary, the trust can be structured so that beneficiaries do not receive any distributions until they reach certain ages or benchmarks, thereby providing an additional level of control over the heirs’ access to the funds.
  • The owner’s payment of income tax on the conversion actually reduces the taxable estate. By paying these taxes at conversion the owner is essentially pre-paying tax on the heirs’ behalf and getting an estate tax benefit for doing so.

To give you an idea of the potential benefit that converting even a modestly-sized traditional IRA can have, assume that the owner of a $100,000 traditional IRA is currently 40 years old and converts the traditional IRA to a Roth IRA. The owner passes away at age 90 and leaves the IRA to a trust for the benefit of her 30 year old granddaughter. If the granddaughter does not spend the inherited funds, assuming a relatively modest annual pre-tax rate of return of 5% and tax rates at their current levels, the tax-effected impact of converting over the granddaughter’s lifetime (on the horizontal axis) would be as follows.

Given the potential benefit of conversion on estate and wealth-transfer planning, we recommend everyone at least consider the economic impact that a conversion can have on their situation. With the right advice and pro-active planning, taking simple steps now can lead to material savings later.

For those who have converted amounts to Roth IRAs, it is important to determine the beneficiary designations and how they fit into your overall estate plans.

If you have any questions about IRA conversions as part of estate plans, please contact your tax advisor.