Roth conversion as estate planning technique
September 28, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The 2010 lifting of income limits for Roth IRA conversions creates a sizable opportunity to reduce estate taxes. We’ve already discussed Roth IRA conversion basics, and who might want to convert. But if your estate is potentially subject to the estate tax at your death, you have an additional reason to take a close look at this opportunity.
For 2009, the estate tax exemption is $3.5 million. Under current law, the estate tax is scheduled to be completely revoked for 2010 and then in 2011 revert back to a $1 million per person exemption. Very few people think that the current law will stand as is. But no one knows right now what congress will do. So, for planning purposes, it’s prudent to consider Roth IRA conversion if your estate is potentially at or even near current estate tax levels. If you’re not sure about your estate, there’s a neat little calculator at SmartMoney.com.
How does converting help?
When you pass money in a traditional IRA to your heirs, you are passing the funds pre-income-tax. When you pass money in a Roth IRA, you are passing post-income-tax funds. Either way, the total being passed counts toward your taxable estate. So if you pay the taxes on the IRA funds before your death by converting traditional IRA funds to Roth, you reduce your taxable estate by the amount of the income taxes paid.
Let’s look at an example simplified for the case of illustration.
Suppose Mr. Smith has $5 million in assets that he will be passing to his son when he dies. Using the $3.5 million exemption, $1.5 million will be subject to the estate tax, and estate taxes would be approximately $675,000. $1 million of these assets are in a traditional IRA. Mr. Smith is in the 35% tax bracket.
If Mr. Smith converts the $1 million traditional IRA to a Roth, he will pay $350,000 in income taxes for the conversion, reducing his estate to $4,650,000. After conversion, only $1,150,000 will remain subject to the estate tax, and his estate tax will go down to $517,500 – a savings of approximately $157,500.
Other considerations with this strategy:
- What tax bracket is the beneficiary in?
- How much do we expect the IRA to grow between conversion and estimated life expectancy?
- What other estate planning techniques are available to Mr. Smith to otherwise reduce estate taxes?
In any case, if your assets potentially make your estate subject to the estate tax and you have a traditional IRA, converting to a Roth IRA merits consideration as an estate planning technique.
July 2009 Newsletter
July 1, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The July 2009 newsletter is now available online. It reviews some blog information on FDIC insurance limits, establishing an emergency fund, and down market estate planning opportunities. It also covers new information on whether or not you should refinance your mortgage and considerations in diversifying your investments. Click here to read it.
Estate Planning Opportunities in a Down Market
July 1, 2009 by Jean Keener, CFP, CRPC, CFDS · 1 Comment
Note: This article discusses federal tax rules only. Individual states impose their own property transfer taxes using rules that may be different from the federal rules.
Basic Gifting
Each year, you can make gifts of up to $13,000 to anyone you want, to as many people as you want, tax free under the annual gift tax exclusion. You can give away twice that amount if both you and your spouse make the gifts together (this is called gift splitting). And, you can give away an unlimited amount if you pay tuition or medical bills on behalf of another person (just be sure to make these payments directly to the school or health-care provider
Family loans
You can lend money to your children at the current IRS minimum interest rate (known as the AFR, which changes monthly), and then potentially forgive an amount equal to the gift tax exclusion each year. (The gift tax exclusion amount is adjusted for inflation; $13,000 is the figure for 2009.
Grantor retained annuity trust (GRAT)
A GRAT is an irrevocable trust with a specified term (e.g., 10 years) into which you gift assets that you expect will greatly increase in value in the future. You receive annuity payments during the trust term, and at the end, your beneficiaries receive any remaining propertyThe transfer of assets to the GRAT is a taxable gift to the trust beneficiaries. The value of the gift for tax purposes is determined based on the current IRS rate (known as the 7520 rate, which also changes monthlyTax savings are achieved because the annuity payments are calculated to result in a gift tax value of zero. It’s anticipated, however, that the actual interest earned will be higher than the 7520 rate, leaving a substantial value in the GRAT at the end of the term. This remaining value is passed on to your beneficiaries tax free.
Intentionally Defective Grantor Trust (IDGT)
An IDGT is an irrevocable trust that has a purposeful flaw (i.e., you retain some control over the trust) so that you, and not the trust entity, pays the income taxes on trust income (thus, an IDGT is ideal when you want to transfer income-producing assets). Even though you retain some control over the trust, IDGT assets will generally not be included in your taxable estate at your deathYou sell assets to the IDGT in return for an installment note, with interest calculated based on the current AFR. There is no gift tax because it is a “sale” (except for an initial gift that “seeds” the trust). However, because you and the trust entity are considered the same taxpayer, no gain is recognized on the sale, and interest you receive under the note is not considered taxable income>Tax savings are achieved because, hopefully, the value leaving your estate via the sale will exceed the value returned to your estate via the note. You also reduce your estate by paying the income taxes on IDGT income.
Charitable lead trust (CLT)
A CLT is an irrevocable trust with both charitable and noncharitable beneficiaries. It’s called a lead trust because it is the charity that is entitled to the first or lead interest from the trust property. After the specified term, the remaining trust property passes to you or another named noncharitable beneficiaryAt the time assets are placed into the CLT, you receive a current gift tax deduction equal to the present value of the income stream that will be going to the charity. The interest rate used is based on the current 7520 rate. The lower the interest rate, the higher the deduction. As with a GRAT or IDGT, it is hoped that the CLT assets will appreciate beyond the 7520 rate, allowing the excess to pass tax free.
These gifting strategies, and others, can turn this economic downturn into a mixed blessing.
June 2009 Newsletter
June 2, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The June 2009 newsletter is now available. It includes articles on the new credit card law provisions, energy-efficient tax credits, estate planning for second marriages, and social security planning. Click here to read it.
April 2009 Newsletter
April 6, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
The April 2009 newsletter is now available online. It includes an update on market conditions, plus information on the Cobra subsidy, writing off worthless securities on your taxes, an estate planning pitfall to avoid, a conversation for parents about saving for retirement vs. college, and a how-to on budgeting. Click here to read the newsletter.
To Will or Not to Will
April 6, 2009 by Jean Keener, CFP, CRPC, CFDS · Leave a Comment
Catchy title, isn’t it? To Will or Not to Will. I would love to take credit for it, but it all goes to the Texas Young Lawyers Association and the State Bar of Texas.
When you do as a resident of Texas, if you don’t have a will, the state of Texas has one for you. It’s possible that the state’s will matches perfectly with your wishes, but that’s not the case in most situations. Texas is a Community Property state, so it becomes especially unlikely when you’ve remarried and there are children from a previous marriage.
In any case, estate planning is an important part of financial planning. This can be as simple as making sure your will, beneficiary designations, and other documents are in order, or much more complex depending on your situation. It can make a huge difference to your heirs in the amount of hassle they have to go through after your death, taxes paid, and preservation of family relationships.
The State Bar Association does a great pamphlet on what happens in Texas if you don’t have a will. It’s called To Will or Not to Will. You should check it out.