A Roth to Reduce Estate Size?

Dave (sorry, one book per guest) asked Are Roth conversions advisable for retired people as a way to reduce estate size?

Hmm, excellent question. Since the estate exemption (In 2012 $5.125M) tends to be a moving target, let’s look at number based on $1M exemption. Along with this, let’s assume a 50% estate tax. An IRA owner with an account valued at $1.4M could potentially have his estate subject to a $200K estate tax. If there were no other assets to pay this tax, the IRA would need to liquidate enough to net the $200K due. On the other hand, with a top tax rate of 35%, the IRA owner could convert to Roth, squeezing the account balance below the Estate Tax exemption amount.

This strategy may help avoid estate tax as well as provide a tax free retirement account to the IRA owners heirs. I’d say that’s not too bad. I think as long as there’s doubt as to what the estate tax exemption is, the conversion may be one approach to take. It helps reduce the estate tax as well as the tax on the RMDs the heir must take each year.

However, one needs to be aware of Income in Respect of a Decedent (IRD). Let me try to explain how IRD works. Say in the above example, $1M was in the value of the house and other assets, and $400K in the IRA which you inherited. The estate paid $200K in federal estate tax, and you have the $400k properly titled and are preparing to take your RMDs each year. When you withdraw your first $10,000, for example, you actually get a tax writeoff of $5000 on your schedule A. Since $200K was paid in estate tax on the $400K IRA you inherited, 50% of all withdrawal carry the opportunity to use an IRD deduction. You must track the remaining IRD each year, and reduce it by the amount taken on each year’s return. This is a pretty good deal and helps reduce the impact of the double taxation of both estate tax and income tax on withdrawal. The problem? Few people have ever heard of IRD. As if the rules for IRAs and Roth IRAs weren’t complex enough.

For most people in retirement who have a decent IRA account, I prefer to suggest small conversions each year, just enough to ‘top off’ their current bracket. I help a woman with her taxes each year. After her standard deduction and exemption, her taxable income is just over $25,000. This puts her marginal rate at 15%. With her RMDs growing each year, she risked having her income bump to the 25% bracket. But years ago, we started converting to Roth. Just enough to put her taxable income right at the line between 15% and 25% marginal rates. This strategy is less about estate size (she has well under $1M in her estate) but more about tax optimization. She’ll avoid paying 25%, and her heirs, two daughters, will both avoid having to pay any tax at all on the Roth accounts.