Tax and estate planning for IRAs after TRA '97.

An Analytical Perspective on the Opportunity to Convert Existing IRAs to the New "Roth IRA"

The heart of the Roth individual retirement account (IRA) is a nondeductible contribution followed by nontaxable withdrawals. The true benefit is a provision that allows a taxpayer to convert an existing IRA to a Roth IRA. The price of conversion is realizing the deferred income of the existing IRA ratably over a period of four years. To enjoy the four-year spread of income, the election to convert the IRA must be made by December 31, 1998. Conversion, without the four-year spread, will continue to be available after 1998.

Initial analysis indicates that the Roth IRA is a superior wealth creation vehicle when compared to the traditional IRA. The key factors will be the client's current income tax situation, his post-retirement tax situation and age. Generally, the younger the client and the larger his IRA, the more likely that an election makes sense.

One of the most important portions of this new law is the suspension of the age 70 1/2 required distribution rules. Taxpayers will not be required to take any distributions from a Roth IRA during their lifetimes.

The conversion right is only available to taxpayers with adjusted gross income of $100,000 or less. Roth IRAs may be rolled over at the death of one's spouse and a rollover IRA can be converted to a Roth IRA.

1998 and Future Income Tax Rates

If tax rates at retirement will be the same or higher relative to the tax rates at the date of the rollover, the Roth conversion election is likely to be advantageous. Further, if a client has net operating loss (NOL), investment tax credit (ITC) or charitable deduction carryforwards, the rollover election will be even more favorable.

The following are some of the important variables to the conversion decision:

* Does the taxpayer have special tax attributes available in 1998, 1999, 2000 or 2001? For example, a charitable deduction carryforward, an NOL carryforward, ITCs, etc.? The presence of these will help reduce the tax paid due to the conversion.

* Can the taxpayer make the conversion in 1998? A four-year spread over which to pay income tax is available in 1998.

* Does the taxpayer have adequate funds to finance his retirement? If so, the suspension of the minimum distribution rules at age 70 1/2 provides a considerable advantage of the Roth IRA.

* Will the IRA be passed through an estate? If so, the payment of income tax due to the conversion will reduce the amount of the taxable estate relative to a regular IRA (which is treated as income in respect of a decedent under Sec. 691 (c)).

* Does the taxpayer have funds outside the IRA that can be used to pay the tax due with the conversion? Under the Technical Corrections Act currently pending in Congress, the payment of the tax out of funds contained in the IRA will be considered a premature distribution, unless the taxpayer is at least 59 1/2 or disabled.

* Does the taxpayer need to use IRA funds to fund a $600,000 unified credit bypass trust? The Roth IRA is an excellent vehicle for funding a bypass trust, because the distributions to the trust beneficiaries will be tax-free.

* By making the Roth IRA election during one's lifetime, the taxpayer will reduce his overall estate, thereby lowering the effect of higher estate tax rates.

Conversion Without Other Variables

To understand the conversion analysis, one must begin with the basic situation.

Example 1: Taxpayer T, age 59, has a $500,000 IRA with $250,000 of outside funds. For ease of analysis, assume that the dollars will be taxed at 28% in both instances.

Note: The following analysis will help in becoming familiar with the basic provisions applicable to Roth IRAs, rather than to determine if a client should convert his IRA to a Roth IRA. As shown below, there is mathematically no difference between converting or not converting, assuming there is no four-year spread, required minimum distribution (RMD) or estate tax. See Table 1, above right.

Table 1: Traditional IRA vs. Roth IRA No Estate Tax, RMD or Four-Year Spread

                      Traditional IRA
       Ending IRA                                   Ending IRA
       and outside      Taxes            Net to     and outside
Year   fund balance     on IRA           family     fund balance

1997     $750,000       $(140,000)       $610,000    $750,000
1998      820,000        (154,000)        666,000     806,000
2003    1,282,499        (248,019)      1,034,481   1,034,481
2008    2,009,468        (399,436)      1,610,032   1,610,032
2013    3,153,972        (643,296)      2,510,676   2,510,676
2018    4,958,583      (1,036,035)      3,922,548   3,922,548
2023    7,808,177      (1,668,545)      6,139,632   6,139,632
2028   12,314,089      (2,687,208)      9,626,881   9,626,881

        Roth IRA

         Taxes        Net to
Year     on IRA       family

1997    $(140,000)    $610,000
1998     (140,000)     666,000
2003            0    1,034,481
2008            0    1,610,032
2013            0    2,510,676
2018            0    3,922,548
2023            0    6,139,632
2028            0    9,626,881

Four-Year Period In Which to Pay Taxes

The four-year deferral of time in which to pay income taxes reduces the present value of the tax liability. During this period, both the after-tax funds and funds that will be needed for the quarterly estimated payments (four estimates) will be working for the taxpayer. This is shown in Table 2 at right.

Table 2: Traditional IRA vs. Roth IRA No Estate Tax or RMD

                      Traditional IRA
       Ending IRA                                    Ending IRA
       and outside      Taxes            Net to      and outside
Year   fund balance     on IRA           family      fund balance

1997     $750,000        $(140,000)       $610,000    $750,000
1998      820,000         (154,000)        666,000     816,500
2003    1,282,499         (248,019)      1,034,481   1,066,298
2008    2,009,468         (399,436)      1,610,032   1,661,274
2013    3,153,972         (643,296)      2,510,676   2,593,202
2018    4,958,583       (1,036,035)      3,922,548   4,055,458
2023    7,808,177       (1,668,545)      6,139,632   6,353,684
2028   12,314,089       (2,687,208)      9,626,881   9,971,615

        Roth IRA

         Taxes       Net to
Year     on IRA      family

1997   $(140,000)    $610,000
1998    (140,000)     676,500
2003           0    1,066,298
2008           0    1,661,274
2013           0    2,593,202
2018           0    4,055,458
2023           0    6,353,684
2028           0    9,971,615

The Degree to Which the Client Will Be Able to Defer Distributions after Age 70 1/2

If a client will not need funds on reaching 70 1/2, the Roth IRA will be more desirable compared to the traditional IRA and related RMDs. The advantage of this additional deferral is shown in Table 3 at left.

Table 3: Traditional IRA vs. Roth IRA No Estate Tax

                      Traditional IRA
       Ending IRA                                    Ending IRA
       and outside      Taxes           Net to      and outside
Year   fund balance     on IRA          family      fund balance

1997    $750,000        $(140,000)       $610,000    $750,000
1998     820,000         (154,000)        666,000     816,500
2003   1,282,499         (248,019)      1,034,481   1,066,298
2008   2,008,096         (378,302)      1,629,794   1,661,274
2013   3,075,521         (439,075)      2,636,446   2,593,202
2018   4,428,734         (433,052)      3,995,683   4,055,458
2023   6,223,771         (256,020)      5,967,751   6,353,684
2028   8,785,983                0       8,785,983   9,971,615

        Roth IRA

         Taxes      Net to
Year     on IRA     family

1997   $(140,000)     $610,000
1998    (140,000)    676,500
2003           0    1,066,298
2008           0    1,661,274
2013           0    2,593,202
2018           0    4,055,458
2023           0    6,353,684
2028           0    9,971,615

Whether the Income Taxes, on Conversion, Will Be Paid from Funds Within or Outside of the Newly Converted Roth IRA

The strongest case for conversion to a Roth IRA exists when the tax liability can be paid from funds outside of the converted IRA. This is shown in Table 4 at left.

Table 4(*): Traditional IRA vs Roth IRA No Estate Tax Fund Tax With Outside Funds

                      Traditional IRA
       Ending IRA                               Ending IRA
       and outside    Taxes          Net to     and outside
Year   fund balance   on IRA         family    fund balance

1997     $750,000     $(140,000)    $610,000       $750,000
1998      820,000      (154,000)     666,000        816,500
2003    1,282,499      (248,019)   1,034,481      1,078,887
2008    2,008,096      (378,302)   1,629,794      1,707,520
2013    3,075,521      (439,075)   2,636,446      2,705,843
2018    4,428,743      (433,052)   3,995,683      4,292,937
2023    6,223,771      (256,020)   5,967,751      6,818,532
2028    8,785,983             0    8,785,983     10,841,308

        Roth IRA(**)

        Taxes       Net to
Year    on IRA      family

1997   $(140,000)    $610,000
1998    (140,000)     676,500
2003           0    1,078,887
2008           0    1,707,520
2013           0    2,705,843
2018           0    4,292,937
2023           0    6,818,532
2028           0   10,841,308

(*) Assumes the Roth IRA election is made on Jan. 1, 1998 and the entire tax liability for that year is funded from assets outside the IRA. Also assumes growth of 10% and income tax of 28% This table further assumes that them is no estate fax.

(**) Since taxes are paid from outside the Roth IRA, the tax Technical Correction Act will not affect this analysis.

The Impact on the Taxation of Social Security Benefits

A potential trap for the unwary will be the impact of the Roth conversion election on the taxation of Social Security benefits. When analyzing the conversion election, one should determine whether the additional conversion income will directly result in a portion of Social Security income becoming subject to regular income tax. However, there is also some tax planning that can be done with regard to Social Security. By converting to a Roth IRA, one can provide sufficient income for retirement and also avoid paying income tax on his Social Security benefits, as the Roth IRA income is not included in the taxable Social Security benefit calculation.

Whether the Client Will Be Subject to Federal Estate Taxes

For many taxpayers with substantial wealth in their qualified plan or IRA, the analysis of whether to convert a traditional IRA to a Roth IRA should include the effect of estate taxes.

If an IRA is converted to a Roth IRA, the overall estate will be reduced by the amount of the income taxes paid, resulting in a lower overall estate tax base.

Example 2: T's only asset is an IRA valued at $1,000,000. If he elects to convert the IRA to a Roth IRA, T's estate will be decreased by approximately $350,000 ($1,000,000 X 35%). After paying the income taxes, $650,000 will remain in the Roth IRA. If T dies in 1999 when the exemption amount is $650,000, the entire Roth IRA will pass tax-free to the bypass trust.

Whether Traditional ERA Funds Will Be Used to Fund the Unified Credit Bypass Trust

Clients will now be asking if they should use their traditional IRAs or Roth IRAs to fund bypass trusts. At first this may seem like a difficult question; the answer, however, may be relatively straightforward. Income tax has already been paid on the Roth IRA. If $650,000 of Roth IRA assets are used to fund a bypass trust, this may actually result in a greater wealth transfer than $650,000 of traditional IRA assets. This is shown in the chart below, which assumes the beneficiaries of the bypass trust are subject to a 31% tax rate.

Value of Assets Passing to the Bypass Trust

                           Traditional IRA   Roth IRA

Exemption amount           $650,000          $650,000
Less income taxes at 31%    201,500                 0

Net to beneficiaries         448,500           650,000

Additional wealth transfer                   $201,500

As shown previously, income taxes severely affect the amount of wealth that actually transfers to the bypass trust. In the instance above, only $448,500 out of the original $650,000 gets passed to the family; if the Roth IRA is used, greater distributions will occur.

Conclusion

Most clients will benefit from the $2,000 annual contribution to a Roth IRA. Further, many clients will benefit from the conversion of traditional IRAs to Roth IRAs. Lastly, many estate planning clients will benefit from the conversion of a traditional IRA to a Roth IRA.

The most critical task for planners will be to become familiar with the situations in which converting an existing IRA to a Roth IRA will be beneficial, and to develop the software, memorandums, flowcharts and graphs needed to analyze and communicate these concepts to their clients.

From Robert S. Keebler, CPA, MST, Shareholder, and Michael A. Bleck, Tax Associate, Schumaker, Romenesko & Associates, S.C., Green Bay, Wisc. (Not affiliated with Grant Thornton LLP)