Could the Roth Conversion Be an Estate Planning Opportunity?

The debate over income tax and the direction of future rates will continue, and you can find plenty of literature to support whether the Roth conversion makes sense when it comes to a question of income tax. Therefore, as you consider the benefit of a Roth conversion for your clients, be sure to include the estate-tax benefits of doing so. They may be the factor in your analysis that tips the balance in favor of conversion.

Estate planning benefits of conversion
An obvious but important benefit of a Roth IRA is a beneficiary's ability to make withdrawals from the account without incurring any tax liability. Unlike a Traditional IRA, which is taxable to the account beneficiary, a Roth IRA account is wholly tax-exempt to the beneficiary–just as it would have been to the deceased owner.

One point to be aware of, however, is that, although a Roth IRA is not subject to RMD rules while the account owner is alive, the beneficiary is required to make withdrawals. At a minimum, a Roth IRA beneficiary who is considered a "designated beneficiary" (i.e., a human being versus an entity) must make minimum withdrawals based upon his or her life expectancy. It should be noted that some trusts may qualify as a designated beneficiary, therefore allowing distributions to be "stretched" over the trust beneficiary's life expectancy. But the ability to continue to grow the contributions in a tax-deferred account and make tax-free withdrawals over the beneficiary's life expectancy is a significant benefit.

Another benefit–not mentioned as frequently–is the estate planning benefit of the after-tax nature by which the Roth account was funded. The Roth IRA account balance consists of after-tax dollars contributed via annual contributions or through a conversion. The payment of income taxes reduces the taxable estate of the Roth IRA account owner. For best results, the tax liability should be paid with dollars outside of the converted balance. A client can view the opportunity to convert as a prepayment of tax on behalf of account beneficiaries, while also reducing the amount of the estate subject to estate tax–at a rate that is substantially higher than the income-tax rate. This benefit is even more pronounced when Roth beneficiaries are in a high-income tax bracket. Consider this point when reviewing who is named a Roth beneficiary.

If you have clients who are converting retirement account balances to Roth IRAs, it is important that you monitor the accounts for performance. If the Roth balance depreciates, the client may be able to "undo" the conversion through a recharacterization, which can help avoid a large income tax liability on what has become a depressed account balance.

The Roth IRA conversion opportunity must be carefully analyzed for each client, but for wealthy clients considering a conversion, the estate planning benefits may be the determining factor in the decision to move forward.

Gavin Morrissey, JD, is the director of advanced planning at Commonwealth Financial Network, in San Diego, California. He can be reached at [email protected].