Roth Conversion As Estate Planning Technique

The 2010 lifting of income limits for Roth IRA conversions creates a sizable opportunity to reduce estate taxes.  We’ve already discussed Roth IRA conversion basics, and who might want to convert.  But if your estate is potentially subject to the estate tax at your death, you have an additional reason to take a close look at this opportunity.

For 2009, the estate tax exemption is $3.5 million.  Under current law, the estate tax is scheduled to be completely revoked for 2010 and then in 2011 revert back to pre-2001 levels with a $675,000 per person exemption.  Very few people think that the current law will stand as is.  But no one knows right now what congress will do.  So, for planning purposes, it’s prudent to consider Roth IRA conversion if your estate is potentially at or even near current estate tax levels.  If you’re not sure about your estate, there’s a neat little calculator at SmartMoney.com.

How does converting help?

When you pass money in a traditional IRA to your heirs, you are passing the funds pre-income-tax.  When you pass money in a Roth IRA, you are passing post-income-tax funds.  Either way, the total being passed counts toward your taxable estate.  So if you pay the taxes on the IRA funds before your death by converting traditional IRA funds to Roth, you reduce your taxable estate by the amount of the income taxes paid.

Let’s look at an example simplified for the case of illustration.

Suppose Mr. Smith has $5 million in assets that he will be passing to his son when he dies.  Using the $3.5 million exemption, $1.5 million will be subject to the estate tax, and estate taxes would be approximately $675,000.  $1 million of these assets are in a traditional IRA.  Mr. Smith is in the 35% tax bracket.

If Mr. Smith converts the $1 million traditional IRA to a Roth, he will pay $350,000 in income taxes for the conversion, reducing his estate to $4,650,000.  After conversion, only $1,150,000 will remain subject to the estate tax, and his estate tax will go down to $517,500 – a savings of approximately $157,500.

Other considerations with this strategy:

  • What tax bracket is the beneficiary in?
  • How much do we expect the IRA to grow between conversion and estimated life expectancy?
  • What other estate planning techniques are available to Mr. Smith to otherwise reduce estate taxes?

In any case, if your assets potentially make your estate subject to the estate tax and you have a traditional IRA, converting to a Roth IRA merits consideration as an estate planning technique.

About the author

Jean Keener, CRPC®, CFDP®

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