Converting IRA to Roth is a financial gift

The switch can bring big state estate tax benefits, too.

The Roth IRA is the ultimate financial gift for retirees and their beneficiaries.

Roth individual retirement accounts have no lifetime required minimum distributions, so you’ll never have to worry about paying higher future tax rates on those funds. In retirement, you can withdraw whatever you wish tax-free. That will keep Medicare IRMAA charges in check, as well as reducing exposure to the 3.8% net investment income tax. It can also qualify you for deductions, credits and other tax benefits that are based on adjusted gross income.

CONTROLLING TAX RATES

One big key to effective tax planning is to control tax rates, and that can be done with Roth conversions. You can control each year’s tax liability by converting any amount you choose, keeping conversion income in low tax brackets.

If an IRA isn’t converted, it will continue to grow and eventually be subject to RMDs, currently at age 73. Once RMDs begin, it’s much harder to control your tax rates and keep AGI low.

WHAT DO YOU GET?

When you convert your IRA to Roth, you pay income tax on that conversion at today’s historically low rates. But what you’re really doing is buying yourself a gift that will pay off for the rest of your life and for 10 years after for your beneficiaries. Under the 10-year rule for inheritors like children or grandchildren, there are no RMDs for years one through nine of the 10-year term, so they can hold on for the full 10 years as their inheritance compounds tax-free.

HAPPINESS!

People with tax-free income are just happier. They don’t have to worry about taxes. It’s hard not to be happy about locking in a 0% tax rate for life, and beyond.

In addition, I’ve found that Roth converters love not having to worry about RMDs and love knowing their beneficiaries will also enjoy tax-free benefits for 10 years after death.

But the best part is that they can enjoy the accumulation of their Roth accounts, realizing they can retain all those gains tax-free. In a world where we’re bombarded with taxes on all types of income and gains, there’s something special about knowing that Roth IRA earnings are never taxed.

ESTATE TAX SAVINGS

In essence, when you convert your IRA to a Roth IRA, you’re paying a tax that your beneficiaries would otherwise have to pay. When you pay a bill for someone else, that’s a gift, but a conversion doesn’t count as a gift for estate or gift tax purposes.

While Roth IRAs are income tax-free, they are still subject to federal estate taxes. Yes, the federal estate tax exclusion is currently $12.92 million per person ($25.84 million for a married couple), so most IRAs will not trigger a federal estate tax. But that’s not true for state estate taxes. While the majority of states have no estate tax, some not only have an estate tax but have much lower exemption amounts that can trigger huge tax bills.

For example, New York currently has an estate exclusion of $6.58 million, but like some other states, once your estate value exceeds that amount (even by one dollar), you don’t pay tax just on the amount in excess of that exclusion — you pay tax on a much larger amount. These states have what’s commonly known as a “cliff tax,” which removes chunks of the exclusion and results in effective tax rates that can easily exceed 200%.

EXAMPLE

If your New York estate is $6.68 million (just $100,000 higher than the state exemption), the state estate tax would be $252,516, an effective rate of 252% on that $100,000 excess. And it’s all due to the cliff tax quickly accelerating the tax bill.

New York has no gift tax, so you could give away $100,000 and completely eliminate the estate tax. But the state has a three-year lookback in which, if you die within three years after giving the gifts, they are added back to your estate.

A better solution (with no lookback period) is a Roth conversion. Converting only around $200,000 to a Roth IRA can easily eliminate the entire $252,516 tax bill. Assume, for simplicity, a combined top federal and New York state tax rate of 50%. That would require you to pay a $100,000 tax to convert $200,000. But paying that tax would reduce the estate by that $100,000 and eliminate a potential $252,516 tax bill!

In essence, the state will be paying the tax cost to convert, with your family ending up with much more. And the beneficiaries will be inheriting a Roth IRA that is both income tax-free and estate tax-free.

That’s great for your heirs — but what’s in it for you? Well, your lifetime income will be reduced as a result of lower RMDs, since $200,000 of IRA funds were converted to Roths. It’s win-win all around — a giant-size tax savings. Imagine saving a quarter million dollars in taxes for the family, and getting a tax-free Roth in the deal.

MASSACHUSETTS

Some states, like Massachusetts with only a $1 million exclusion, can generate a much higher state estate tax. For example, the same size estate as in the example above ($6.68 million) would result in a whopping $597,040 state estate tax in Massachusetts. Oregon, which also has only a $1 million exclusion, would impose an even higher state estate tax of $625,900 on the same size estate. Yikes!

For a complete listing of state estate tax exclusion amounts, go to the American College of Trust and Estate Council’s state death tax chart, a valuable resource that’s continuously updated. Use this chart to calculate how Roth conversions can benefit clients living in states with high estate taxes and low exclusion amounts.

The Roth IRA conversion is a true gift all around, with relatively little cost compared to its significant long-term tax savings. Take advantage of it before the IRS and state tax collectors take advantage of you — and your heirs.

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com.