Pre-tax v. Roth Estate Tax Issues (IRD?)

Income in Respect of a Decedent (IRD)

In general, Federal Estate Taxes may impact the pre-tax v. Roth analysis since IRC §691(c) provides an income tax deduction to the beneficiary that is equal to estate tax paid resulting from the tax due on the receipt of assets from an IRA or other qualified plan; however… the IRD rules that provide the applicable deduction for Federal estate taxes, do not apply to State estate taxes.

In general, the IRD deduction will not offset all income tax due if the IRA or other pre-tax assets are significantly greater than other assets subject to federal estate tax; therefore…

Conversion of a pre-tax IRA to a Roth IRA, does not typically result in the efficient pre-payment of income taxes for beneficiaries. However, since a Roth IRA is not subject to RMD, it does facilitate the “Super-stretch” payments to nonspousal beneficiaries.

The examples that follow illustrate when and how the IRD deduction impacts the net after-tax value of a an individual’s estate payable to beneficiaries.  They do not consider the impact of the super-stretching payments from a Roth IRA to nonspousal beneficiaries.  To see how super-stretching impacts the outcome to nonspousal beneficiaries, see “Stretch v. Super-stretch”

Example 1:  Pre-tax Assets do not exceed other Estate Assets

Individual has $2M in IRA assets, $4M in other assets for a $6M total estate.  For this and the other examples that follow we assume that the Federal estate tax exemption is $3.5M (the actual exemption for 2009 which is unlimited in 2010; and based on conventional wisdom, not law, will revert back to $3.5 for 2011 moving forward, or perhaps 2010 moving forward).  Therefore, for purposes of this example, this individual’s estate is subject to Federal estate tax on $2.5M.

Convert to Roth As shown below, conversion of the entire pre-tax IRA, results in a $2M Roth IRA and a $700,000 income tax bill thereby reducing the taxable assets of $4M to $3.3M, and the taxable estate to $5.3M.  Therefore, the taxable estate in excess of $3.5M is now $1.8M versus $2.5.

The net estate with the Roth IRA is now $4,490,000, while the net after-tax estate is with the pre-tax IRA is $4,875,000; however… The heirs who inherit the pre-tax IRA will pay the $700,000 income tax upon receipt of those assets so it appears (assuming their tax rate is 35%) that the total estate net after-tax is really only $4,175,000.

Pre-tax IRA Convert to Roth IRA
IRA Assets $2,000,000 $2,000,000
Other Assets $4,000,000 $4,000,000
35% Income Tax on
IRA Conversion

(0)

$2M x 35%=

(700,000)
Total Estate $6,000,000 $5,300,000
Estate Tax
(45% xs $3.5M)
$6M – $3.5M =
$2.5M x 45% =

(1,125,000)
$5.3M – $3.5M =
$1.8M x 45% =

(810,000)
Net Estate $4,875,000 $4,490,000

35% tax
on IRA

$2M x 35% =

(700,000)

(0)

Value Net After-tax

$4,175,000

$4,490,000

The chart above indicates that the estate’s beneficiaries receive more if the individual converts, which is true if the heirs do not take advantage of the IRD deduction; however, the outcome differs dramatically if the heirs do take the IRD deduction as shown below:

Pre-tax IRA Convert to Roth IRA
IRA Assets $2,000,000 $2,000,000
Other Assets $4,000,000 $4,000,000
35% Income Tax on
IRA Conversion

(0)

$2M x 35%=

(700,000)
Total Estate $6,000,000 $5,300,000
Estate Tax
(45% xs $3.5M)
$6M – $3.5M =
$2.5M x 45% =

(1,125,000)
$5.3M – $3.5M =
$1.8M x 45% =

(810,000)
Net Estate $4,875,000 $4,490,000
IRD Deduction
(45% estate tax on IRA)
$2M x 45% =
(900,000)
35% tax on IRA
after IRD Deduction
$2M – $.9M =
$1.1M x 35% =

(385,000)

(0)

Value Net After-tax

$4,490,000

$4,490,000

Commentary Unfortunately, very few heirs realize they are entitled to this deduction.  In researching this subject, I interviewed countless CPAs, tax attorneys and other tax professionals regarding the IRD deduction.  Most said they knew it existed but had no idea how it actually applies.  Others said of course they knew what it is and how it applies but that it did not matter to their client, the future decedent for whom they were doing the estate plan; rather, it mattered only to the beneficiaries who they typically did not represent. Lastly, the outcome above may change in favor of the Roth if the individual is subject to State estate taxes since the IRD deduction typically does not apply to State estate taxes.

Keep in mind that this conclusion does not consider the impact of super-stretching distributions to beneficiaries of Roth IRAs.  See: “Stretch v. Super-stretch” and  Case Studies

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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