Roth conversions and estate planning

Converting your traditional IRA to a Roth IRA could have important implications for your estate planning strategy.

Beginning this year, you can convert to a Roth regardless of your income or tax-filing status and spread the pre-tax income equally across 2011 and 2012. Should you decide to do so, it also may be a good idea to consider the impact a conversion could have on your estate planning decisions.

Here's why: A traditional IRA generally consists of pre-tax contributions and tax-deferred earnings that are taxed as ordinary income when the owner takes distributions. Leaving this account to your heirs means they might pay federal taxes twice—once on the estate (if it's large enough to incur estate taxes) and again when taking distributions.

Conversely, a Roth IRA consists of after-tax dollars that don't require the account owner to take minimum distributions. Qualified distributions* are also tax-free. (Non-spouse beneficiaries must take required minimum distributions when the account owner dies, but they aren't taxed on the qualified distributions.)

So converting your traditional IRA to a Roth IRA could make sense as an estate planning tool, since it's generally better to pass along assets that don't carry an "embedded" tax liability. The trade-off is that you could pay a substantial tax bill upon conversion. But your beneficiary then would pay only the estate tax while the account continues to grow tax-free.

The estate's value is reduced by the income taxes paid on the conversion. For instance, if you're converting $500,000 to a Roth IRA and your marginal tax bracket is 35%, the value of your estate (and the amount of estate tax) would be reduced by the $175,000 tax bill due on the conversion. Assuming a 45% estate tax rate on the $175,000, your beneficiary could save $78,750.*

Generally speaking, converting can make sense when the traditional IRA owner:

• Is in a tax bracket lower than or equal to the beneficiary's.
• Can pay the conversion taxes without using IRA assets.
• Doesn't expect to need the IRA money within five years.

An IRA owner planning a Roth conversion can consider contributing to a charity in the same year to help offset the income tax liability of the converted amount. However, it's usually better not to convert if you've named the charity as an IRA beneficiary, since it wouldn't have to pay income taxes on withdrawals anyway.

Don't forget that designating beneficiaries supersedes a will; make sure your beneficiaries are updated so your money will go to those for whom it's intended.

Estate planning is a very personal matter that requires you to carefully consider the possible impacts on yourself and your heirs. It's a good idea to consult with a tax-planning professional to help you make the decision that's right for you.

* Qualified distributions generally are taken more than 5 years after the first contribution to the Roth IRA, and upon death, disability, or after attaining age 59½.

** These figures assume a taxable estate and flat income and estate taxes. Actual tax due or saved may be affected by other deductions or credits.

Notes: 

• All investments are subject to risk.
• When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.