Roth Rules for Retirees: Factor in Estate Taxes

Call it a pig in a poke, a moving target or some other unprintable term. But whatever you call it, deciding whether to convert a traditional IRA into a Roth is especially complex if you might leave your heirs a taxable estate.

All things being equal, a Roth conversion makes sense for many people in this situation, since it can reduce estate taxes. Unfortunately, the estate-tax question is in such flux it’s impossible to know who might be subject to it or what the tax bite might be.

But if you think you might face the estate tax, this could tip the balance in favor of converting.

Under the Bush tax cuts passed in 2001, there is no estate tax for people who die in 2010. But the law’s sunset provision calls for estate taxes to return in 2011, charging 55% against assets above $1 million.

The House has passed a bill setting the post-2010 level at 45% for estates above $3.5 million, but the Senate is still divided on the issue. Most experts expect Congress to eventually settle on exempting at least the first $3.5 million, but a stalemate could leave the $1 million level in effect.

That obviously makes it impossible to figure the exact role estate taxes will eventually play in the Roth conversion decision, but the basics are fairly simple.

The typical conversion decision hinges on the fact that withdrawals from a traditional IRA are taxed as income, at rates as high as 35%, while Roth withdrawals are tax-free. Converting a traditional IRA into a Roth triggers a federal income-tax bill on deductible contributions and investment gains in the old IRA. Generally, converting makes sense for investors who expect to be in a higher tax bracket in retirement than when they convert, since paying at today’s lower rate means avoiding tax at a higher rate later. (Use the Roth IRA Conversion Calculator to weigh the options.)