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Example 2: Pre-tax Assets do exceed other Estate Assets

Same facts as example 1 except the individual has $4M in IRA assets, $2M in other assets for a $6M total estate.

	Pre-tax IRA			Convert to Roth IRA
IRA Assets		$4,000,000			$4,000,000
Other Assets		$2,000,000			$2,000,000
35% Income Tax on IRA Conversion		(0)		$4M x 35%=	(1,400,000)
Total Estate		$6,000,000			$4,600,000
Estate Tax (45% xs $3.5M)	$6M – $3.5M = $2.5M x 45% =	(1,125,000)		$4.6M – $3.5M = $1.1M x 45% =	(495,000)
Net Estate		$4,875,000			$4,105,000
IRD Deduction (estate tax on IRA not to exceed total estate tax)	$4M x 45% = $1.8M; $1.8M is > $1.125M; therefore, IRD deduction = (1.125M)
35% tax on IRA after IRD Deduction	$4M – $1.125M = $2.875M x 35% =	(1,006,250)			(0)
Value Net After-tax		$3,868,750			$4,490,000

Example 2 demonstrates that the benefits of converting increase when all IRA assets do not yield an IRD deduction (and this may also apply dependent on State estate taxation).  Specifically in this instance, the amount subject to estate tax is only $2.5M; therefore, $1.5M of the IRA assets ($4M – $2.5M = $1.5M) receive no benefit from the IRD deduction.

The IRD deduction is 45% x $2.5M or $1,125,000, not 45% x $4M or $1,800,000; therefore, the beneficiaries basically lose an IRD deduction equal to $675,000 ($1.8M – $1.125M = $675,000).

In this general fact pattern (more pre-tax assets than other assets), the differential of net after tax value to heirs by leaving assets in the pre-tax IRA compared to conversion to a Roth IRA (and prepaying the income tax on the pre-tax IRA assets) is calculated as follows:

$1.5M x 45% (Federal Estate Tax) = $675,000 (lost IRD deduction)

$675,000 x 35% (Federal Income Tax) = $236,250 conversion advantage

Closing Commentary 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