Apparently the Estate Tax will return next year with a one million dollar exemption.
Many people have a large part of their estate in IRAs. Is the estate tax based on the total value of the IRA or the value of the IRA less an allowance for state and federal taxes owed?
If it is the former, then is there value to convert the IRAs to Roth IRAs and paying the taxes due from the proceeds? This would reduce the value of the IRAs by perhaps 30% and no future income taxes would be due (hopefully.)
State and federal taxes owed on what exactly? The IRA or the estate as a whole? If the IRA is a Roth, and all income taxes due while the person was alive have been paid, then the only potential tax incurred is an estate tax, and the Roth IRA's beneficiaries never pay any tax on distributions from the Roth, assuming the five year rule yada has been met. Knock on wood that Congress does not change the law on any of this. If the IRA is a traditional IRA, then the beneficiaries pay income tax on the distributions.
The estate tax is based on all assets at death or within six months of death (if memory serves), including the total value of any IRAs less nothing.
It is definitely worth comparing the value of the estate and hence the associated estate tax (if any) (1) by converting; and (2) by not converting.
Run the numbers. I think the only caveat is how sure you are that death will occur in 2011 and, if the death does not occur in 2011, guessing what will happen to the tax in subsequent years and whether the Roth IRA conversion will still make sense (and cents).
Point of reference for other readers: For 2011 so far, the federal government will take 55% of the amount over $1 million. So if the estate is currently valued at 1.5 million, with $0.5 million being in a Trad IRA, then
(1) With conversion to Roth -- Taxes paid = $150k on conversion + $192,500 estate tax Total left to beneficiaries before state taxes = $1,157,500, with no income taxes being due on beneficiaries' distributions, assuming five year rule is met
(2) Without conversion to Roth -- Taxes paid = $275,000 estate tax Total left to beneficiaries before state taxes = 1,225,000 with income taxes being due on distributions to beneficiaries
I believe years and years ago it was the latter, but has definitely been the former for a long time.
Generally, this is advantageous, and I have done this. Be advised, however, that if the estate is taxed (i.e. pays estate tax), then the beneficiary of the IRA may be able to deduct the estate tax paid on the IRA when the IRA distribution is taken. For example, if the IRA is worth $100K (all pre-tax), and the estate paid $50K in estate taxes, then possibly the beneficiary may be able to deduct the $50K when receiving the taxable $100K from the IRA.
See Pub 559, p.11 - Inherited IRAs. "If a beneficiary receives a lump-sum distribution from a traditional IRA ... the distribution is taxable in the year received as _income in respect of a decedent_ up to the decedent's taxable balance." That's the magic phrase - income in respect of decedent - IRD. At the end of page 11, you'll find a section entitled "Estate Tax Deduction" that explains how you get a deduction for estate taxes paid when receiving IRD.
I do not want to nitpick, but I ran some numbers using the 2011 estate tax rate and Franksplace's stated conversion tax rate of 30%. Unless I am missing something, whether a Roth conversion will assist with estate taxes and subsequent taxes seems to me to be very situation specific. Do you care to share why you say it is generally advantageous to convert in this instance?
This subject (converting to a Roth to allegedly help with estate and subsequent taxes) was mentioned recently in a thread at misc.taxes.moderated as well. It was not really resolved, or at least I countered the point and no one responded.
This is good information. As you probably know well Mark, but for others, I see Pub. 590 on IRAs is quite explicit about this option, too, per page 20 of
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I seethe beneficiary has to itemize on Schedule A but given the amounts ofestate taxes potentially deductible, it should often pay to do so,assuming the beneficiary prefers a lump sum distribution. Running some hypotheticals on a spreadsheet sure points out the advantage of this tax break. The question I have not considered at length is the drawbacks for the beneficiary of a lump sum distribution from a tax protected IRA. Following up with the hypothetical I presented above, and assuming the beneficiary is in the 15% tax bracket: Sticking with the Traditional IRA and taking taxable distributions over the beneficiary's life argues for a small advantage for converting to a Roth. But taking the lump sum distribution gives a small advantage to sticking with the Trad IRA. It seems the main guideline here should be the same as that for conversions in general: If the beneficiary's expected, effective tax rate is higher than the conversion tax rate, then convert to a Roth. If not, do not convert.
Doh on me. The beneficiary of the Trad IRA who takes a lump sum distribution per my hypothetical is very likely going to land in a much higher tax bracket (like 33% if the 2009 tax brackets are any guide), even after deducting the estate taxes paid.
But if the beneficiary's effective tax rate drops just a little, to say around 13%, the Trad IRA is the better route.
Wrong for the hypothetical I gave. See above.
Wrong. It really depends on the estate size; how much of the estate is the IRA; and the aforementioned tax brackets. Spreadsheet scenarios should be run for the specific case.
I was considering the case where the Roth conversion is done before death but it appears that, if the estate tax is deductible, then it is a wash.
Before death Convert IRA to Roth IRA: 100k - 30%*100 = $70k Pay 50% estate tax .5* 70 = $35 k after tax
After death, estate tax deductible Borrow $50k to pay estate tax Convert IRA to Roth IRA 100k - 30%*50k = $85k Repay estate tax loan $85k - $50k = $35 k after tax
If the conversion resulted the estate falling below the ET threshold (e.g. $1000k - 30% = $700k), then before death is better.
Apologies. I stand corrected. And it doesn't matter what the estate tax rate is, or what the ordinary income tax rate is. All that matters is that the owner and the beneficiary have the same ordinary income tax rate.
To abstract: let E be the estate tax rate, T be the ordinary tax rate, and I be the IRA amount.
If you convert after death, the estate pays EI, leaving I * (1-E). This happens to be exactly the amount that is subject to the ordinary income tax upon conversion, because you get to deduct EI estate taxes. So, after paying the ordinary income tax, you're left with (1-T) * I * (1-E)
If you convert before death, then the IRA value is reduced to I * (1-T). You pay estate taxes of E on this (leaving 1-E). So after all taxes, you're left with (1-E) * I * (1-T).
In this latter example, you'd have no estate tax, thus no deduction, and the after death, after tax value of the IRA would still be $700K (inherit $1M estate-tax free, but with a 30% tax liability). A wash.
You can break the problem up into two parts - the part of the IRA that brings the estate over the estate tax limit, and the part that remains within the $1M limit. It is a wash on the amount below $1M, since there's no estate tax involved. And we've just seen that is appears to be a wash on the part above the estate tax threshold.
There are other planning reasons to consider or reject the conversion - after death, what you have is an inherited IRA. If the beneficiary isn't a spouse, you're stuck with that form of IRA. See, e.g. this page from Fairmark.com:
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(look for the Inherited IRAs section). Mark Freeland snipped-for-privacy@nyc.rr.com
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