Roth Rules for Retirees: Factor in Estate Taxes

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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.)

But there’s another twist when estate planning comes into play, since both traditional and Roth IRAs are counted as part of their owner’s estate. If nothing changes, an investor who dies in 2011 or later could leave an IRA subject to a 55% tax rate, or 45% if the House measure becomes law.

Converting to a Roth would not allow you to avoid that tax, but the money spent on the conversion tax would reduce the size of your estate. If you spent $50,000 on conversion tax today, you could reduce your estate tax by $27,500, assuming the 55% rate. You’d come out ahead if the conversion triggered a tax of, say, 35%.

Of course, converting to a Roth also means your heirs won’t have to pay income tax when they withdraw the IRA you leave them, as they would if it were a traditional IRA. This could be especially valuable if you think your heirs’ tax bracket will be higher than yours at the time you convert.

With the estate-tax rules up in the air, it’s all a bit of a muddle. Still, estate taxes are worth keeping in mind as you weigh the conversion issue, and it’s definitely worthwhile to keep abreast of the estate-tax debate.

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