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.
The surviving spouse can qualify for the conversion by having a modified adjusted gross income (MAGI) of less than $100,000 in the year the conversion takes place. After the conversion, the spouse must pay the federal and state income taxes resulting from the conversion.
Life insurance coverage on the original IRA owner can provide the funds to pay these income taxes. The policy may be owned by either the IRA owner or the spouse; the spouse should be both the IRA beneficiary and the policy beneficiary. At the insured/IRA owner’s death, the spouse may use the income tax-free death benefits to pay the income taxes on the conversion.
Example: Bill Smith (age 70) has a traditional IRA worth $1,000,000 growing at 8% annually. His wife, Mary (age 68), is the beneficiary. Bill is in reasonably good health. They are in a 35% income tax bracket. Bill doesn’t need the IRA for retirement income. He would like to convert it to a Roth IRA for Mary and their children, but he doesn’t want to pay $350,000 in income tax costs.
Bill decides to use part of the after-tax portion of his required minimum distributions to pay the premiums on a $400,000 life insurance policy on his life. Mary will own the policy and be the beneficiary. At his death, she will roll over the IRA to her own name. Then she will convert it to a Roth IRA. She will use the policy death benefit to pay the income tax costs of the conversion.
Let’s assume Bill dies at age 80 and the IRA balance has grown to $1,354,720. Let’s also assume that Mary is in a 28% income tax bracket after Bill’s death; their children are in a 35% income tax bracket. If Mary rolls the IRA over and then converts it to a Roth IRA, income taxes of $368,314 will be due (at 2007 rates). She can use the $400,000 income tax-free death benefit to pay the income taxes.
She then owns a Roth IRA and can name her children as beneficiaries to receive the remaining account balance at her death. The Roth IRA can continue to grow income tax-deferred without any required minimum distributions until Mary’s death. All distributions from the Roth IRA to Mary and the children after the conversion will be income tax-free.
Using life insurance to pay the income taxes can be an economical strategy, depending upon the health and age of the insured and spouse. Mary won’t have to use her cash, liquidate assets or take a distribution from the IRA.
The life insurance death benefits should not create any estate tax problems for either Bill or Mary. At Bill’s death, the death benefits should qualify for the estate tax marital deduction when they are paid to Mary. If they are used to pay income taxes, the death benefits will be removed from Mary’s estate.
Of course, the Roth IRA balance will be part of her estate, but that shouldn’t adversely impact the children since the traditional IRA would have been part of Mary’s taxable estate if the conversion hadn’t taken place.
Owners of traditional IRAs can give their loved ones the opportunity to have a Roth IRA by using after-tax amounts to purchase life insurance on their lives, which can provide income tax-free dollars to help pay the taxes triggered by the conversion.