Here are some tips about estate taxes and IRAs. If your estate is large enough to be subject to estate taxes, you need to know that a traditional IRA is subject to estate tax on the IRA value prior to income tax being paid. This can amount to a tax on a tax, since estate tax will be paid on any amount used to pay income tax. By contrast, on a Roth IRA no income tax would be due, effectively reducing the size of the taxable estate. So, for example, if an account owner converts to a Roth IRA shortly before dying, the income tax cost of the conversion is completely removed from the account owner’s taxable estate.
Deathbed conversions are not the typical Roth scenario. A Roth IRA achieves the most benefit if it’s owner (or the surviving spouse named as designated beneficiary) lives for many years following the creation of the account.
Whether or not you have concerns about estate taxes and IRAs, a Roth IRA allows you to build wealth that you can pass to beneficiaries. By contrast, traditional IRA owners must take required minimum distributions (RMDs), which cut into the tax-deferred growth of the account.
If you have traditional IRAs with assets that you are likely never to need during your lifetime, you should evaluate (with the advice of a qualified financial advisor) whether it might be advantageous to convert some or all of your IRA to a Roth IRA. Since 2010, there are no income limits for conversions to a Roth IRA.
If you name your spouse as beneficiary of your Roth IRA, your spouse can roll the IRA over into his or her own Roth IRA. A spouse beneficiary is not required to take distributions during his or her lifetime. This makes continuing growth possible. The surviving spouse can name children or grandchildren as beneficiaries, further leveraging the benefits of the account.
You might consider a Roth IRA conversion in a year when you have low taxable income due to job loss, business losses, or recent retirement. Consider Social Security benefits in the year of the conversion rollover. The income from the rollover could increase the amount of Social Security benefits subject to tax or trigger taxation of Social Security benefits by increasing the AGI to the taxable threshold.
While there are no income limits for conversions to a Roth, there still are income limits for making contributions to Roth IRAs. In 2014 the AGI phase-out range for Roth IRAs is $114,000 to $129,000 for singles and heads of household, and $181,000 to $191,000 for married couples. (Married couples earning more than $191,000 cannot contribute to a Roth IRA for 2014; between $181k and $191k the allowable amount decreases). However, investors who earn more than these income limits sometimes use what is known as a “backdoor” strategy by contributing to a traditional non-deductible IRA and then immediately converting to a Roth. Be sure to talk to your advisor about the pro rata rule before pulling the trigger on a conversion.
While you must have “earned income” to contribute to a Roth IRA, you can contribute at any age and there are no mandatory distributions. A non-working spouse can contribute based on the working spouse’s income. It is also possible to contribute and convert in the same year.
One other idea is to fund a Roth IRA for a minor grandchild who has earned income from a part-time job. The annual contribution would be limited to the lesser of the child’s earned income or the $5,500 maximum contribution.
Your IRAs, tax planning, and beneficiary designations are part of your overall estate plan. Consult your estate planning attorney and financial advisor to maximize the effectiveness of your plan and benefit for your family.
© Karen S. Hindson, Hindson & Melton LLC February 12, 2014