Newsletter: March 2010
March 16, 2010
In this issue: Roth IRA Conversion and Federal Estate Tax Planning in 2010
ROTH IRA CONVERSIONS
To "Roth" or Not to "Roth"...
With all of the recent chatter about Roth IRA conversions, we thought this month's newsletter might be the appropriate venue for us to share some of our thoughts and insight on the issue.
We note going into this discussion that because no two clients are ever the same, there will likely be numerous factors and considerations that must be analyzed on a case-by-case basis in determining the proper course of action in any given case. In our experience so far, it is obvious that a Roth IRA conversion is a very serious decision that should only be made after very careful deliberation.
- There's No Such Thing as a Free Meal. So it's not surprising that you'll have to give something up in order to obtain the benefits of a Roth IRA. The most obvious "cost" related to the conversion, of course, is the resulting income tax liability that the conversion will generate.
In our experience, this cost will prevent most individuals from converting significant account balances to Roth IRAs. Consider that at the end of 2008, $3.5 trillion was invested in traditional IRAs compared to only $165 billion in Roth accounts. Understandably, most of us do not want to part with our money now to avoid income taxes at some time in the future.
- Cost / Benefit Analysis. Because there is an obvious cost to convert to a Roth IRA, one of your objectives must be to offset that cost with the tax advantages that a Roth IRA will offer.
It is important to note, however, that it will take some time before the benefits of converting will "make up" for the income tax cost of the conversion. How much time it will take before you arrive at this "make up" point can only be assumed, as there are no guarantees with regard to market performance. In addition, other intervening events (such as early withdrawal by the beneficiaries) may push back or negate the benefits of the conversion.
- A Modest (Alternative) Proposal. In many circumstances, we believe that the capital cost of conversion can be more effectively deployed. The structure of this alternative arrangement (discussed below) may also secure significant estate and income tax benefits that are not otherwise available with a Roth account.
The alternative strategy alluded to above and described herein (a) takes maximum advantage of the ability to stretch IRA distributions and (b) funds the income tax costs of IRA distributions in a tax efficient manner. In addition, it also eliminates the need to expend capital to cover the income tax cost of a conversion.
The following is a very general description of a strategy that we have developed as an alternative to a Roth conversion, using facts taken from an actual case.
- Client is widowed and age 65. She has one child and one grandchild.
- Client's IRA account balance is $500,000. Assuming an income tax cost of 40%, the capital cost of converting the account to a Roth IRA would be $200,000.
- Instead of converting the IRA and naming her child as the beneficiary of the account, assume that the client foregoes the conversion and names as the IRA beneficiary a conduit IRA trust (to allow for distributions based on the trust beneficiary's life expectancy) for the benefit of her grandchild.
- Assume further that in order to replace the $500,000 in the IRA that her child would have otherwise inherited, the client purchases a life insurance policy on her own life with a death benefit of $500,000. Also assume that the annual premium cost of the insurance policy will be $10,000.
- Assuming a 5% rate of return on an investment account with a balance of $200,000 (the amount that the client "saved" by not converting her IRA), the client has generated the $10,000 premium cost for the policy. In other words, so long as the principal is maintained and the account's annual rate of return is at least 5%, the policy premiums could be paid for from the earnings on the amount "saved" by foregoing conversion.
- On the client's death, her child will receive the policy's $500,000 death benefit income, estate and gift tax-free.
- In addition, the client's child would also receive the $200,000 that would have otherwise been spent to pay the income tax cost of the conversion. In other words, this money would go to the client's child, and not the IRS.
- With regard to the client's IRA, the use of her grandchild's life expectancy (as opposed to her child's) in determining the required minimum distributions ("RMDs") from the IRA would allow the IRA account value to grow at an astounding rate. To illustrate this point, consider that total RMDs to a grandchild will typically be at least 3 times more than the total RMDs payable to a child due to the wide age difference between those two generations.
There are other planning options available in the scenario described above that may further favor keeping the IRA and not converting to a Roth. You can find an article on Family IRA Trusts in the News & Publications section of our website. Reading this will be helpful to understanding the issues and the planning ideas discussed above.
FEDERAL ESTATE TAX PLANNING IN 2010
Administration's 2011 Budget May Shed Light on Things to Come.
In what is unlikely to surprise many advisors in the "know", a report by the Treasury Department detailing the Administration's 2011 fiscal year revenue proposals includes a presumption that the 2009 estate and GST tax rules will be made permanent. If this presumption proves accurate, it would mean a return of the 2009 $3.5 million federal estate tax exclusion and GST exemption, as well as the $1 million gift tax exemption.
Of substantially more interest, however, the Treasury Department's publication reveals some other proposals made by the Administration:
- Authorize regulations under Section 2704(b) of the Internal Revenue Code to create a new category of "disregarded restrictions" that would be ignored in valuing interests in family limited partnerships, corporations or LLCs to eliminate or reduce many of the current valuation discounts for such interests.
- Require Grantor Retained Annuity Trusts ("GRATs") to be established using a 10-year minimum term.
- Also, preclude the use of "zero-gift" GRATs (also known as Walton GRATs) and GRATs with reducing payments.
- Require the use of the values reported on an estate tax return as the basis of assets reported on income tax returns.
- Increase the reporting requirements for sales of life insurance policies.
- Establish a rebuttable presumption that any trust to which a U.S. person makes a transfer has a U.S. beneficiary, causing the trust to be a grantor trust under Code Sec. 679.
Only time will tell how far any of these proposals will go in the Congress, but the enactment of any of them will have far-reaching consequences in terms of planning for our clients. We will continue to do our best to keep you up-to-date any emerging developments in these areas!
Please contact Smith and Condeni for more information. We look forward to hearing from you.