Many owners of traditional IRAs will not use up all the funds in their IRAs during their lifetimes. IRA balances are often passed on at death because:
o Owners want to take maximum advantage of their IRA’s ability to provide income tax deferral and long-term growth.
o Owners who terminate a traditional IRA during life may trigger a large income tax liability.
o Continuing the IRA for the beneficiary is automatic through the beneficiary designation.
Owners who don’t need IRA distributions for living expenses will probably take out only the required minimum distributions and leave the balance to grow income tax-deferred. If the spouse is the named beneficiary, he/she may roll it over into his/her own name to continue to leverage the income tax benefits.
For an asset that is regularly passed down to other family members, surprisingly little estate planning is done for traditional IRAs. This is understandable. Wills don’t affect IRAs because they come with a built-in estate planning tool: the beneficiary designation. Also, transferring ownership of an IRA before or after the owner’s death runs the risk of terminating its income tax-deferred status.
Inheriting an IRA as a beneficiary may not be cause for celebration. That’s because the beneficiary doesn’t receive a step up in basis on the IRA. Although any future IRA growth remains income tax-deferred, every dollar distributed to a beneficiary is fully taxable at federal rates of up to 35%. (State taxes may also be due.) Thus, beneficiaries inherit an IRA that has an income tax “liability” attached to it.
For example, a $1,000,000 traditional IRA provides $650,000 in net-after-tax distributions to a beneficiary who is in a 35% marginal income tax bracket. From the beneficiary’s perspective, a Roth IRA could be a better asset to inherit because its distributions are income tax-free.
Indeed, IRA owners who don’t necessarily need the income from the IRA may believe it makes better sense to “prefund” the tax on the asset through conversion because the beneficiaries will likely be in a higher marginal income tax bracket. These owners would love to pass a Roth IRA on to their families, but they don’t want to pay the income tax costs of converting from a traditional IRA to a Roth IRA.
Is there an estate planning strategy that can efficiently convert a traditional IRA to a Roth IRA at the owner’s death? Yes, depending upon a number of factors. If the IRA owner is insurable and is likely to be survived by a spouse, life insurance may provide the funds to overcome the biggest obstacle to the conversion: the income taxes due when the conversion takes place.
When the owner of a traditional IRA dies and is survived by his/her spouse who is the IRA beneficiary, the spouse may elect to roll the traditional IRA into his/her own name. Any time thereafter, the spouse may choose to convert to a Roth IRA.