More On Tax Planningfrom The Advisor's Professional Library
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
- Health Insurance: Health and Medical Savings Accounts A Health Savings Account is a trust created exclusively for the purpose of paying qualified medical expenses of an account beneficiary. Although they are popular, they are not without their pitfalls and the regulations can be complicated. Learn more about how to avoid federal taxation on the accumulation and distributions of HSA.
The year 2010 is on track to be very interesting for wealth managers. Because no tax reformation has been enacted as of this writing, what we had previously thought of as impossible has become a reality: 2010 will be known throughout the planning community as the year of no federal estate or generation-skipping transfer tax.
It is expected that Congress will take action and reinstate the estate tax at some point in 2010. But it should also be noted that our logical expectation of how Congress would behave is precisely how we in the financial planning community became subject to this current period of uncertainty. So as we wait for Congressional action--or for the expiration of the repeal and subsequent reinstatement of the estate tax in 2011--I suggest that wealth managers focus on planning opportunities for achieving client goals that are almost certain to stay around, regardless of future changes in tax law.
Roth IRAs and estate planning opportunities
2010 provides wealthy clients with a chance to implement planning that until now had been unavailable to high-income earners. The Tax Increase and Prevention Reconciliation Act of 2005 made this the year in which the modified adjusted gross income limitations associated with converting retirement plan balances to a Roth IRA would be eliminated. So a Roth conversion in 2010--and in subsequent years, assuming that income limitations are not reinstated--may be a fantastic opportunity from the retirement planning standpoint and may also provide often-overlooked estate planning benefits.
Pluses and minuses of the Roth IRA
A Roth IRA provides several advantages when compared with a Traditional IRA. It allows clients to accumulate after-tax dollars and earnings in a tax-deferred account that can later be withdrawn completely tax-free. Additionally, while the account owner is alive, it is not subject to the required minimum distribution (RMD) rules associated with a Traditional IRA. Typically noted downsides are the need to contribute after-tax dollars, the $5,000 contribution limitation ($6,000 for individuals ages 50 and over), and the previous income limitations that had made it an inaccessible planning tool.
There are two ways to fund a Roth IRA:
1. Through contributions (including those to Roth 401(k)s and 403(b)s that are subsequently rolled into Roth IRAs)
2. Through conversion
Who should convert?
Now that there are distinct advantages for a wealthy client to convert to a Roth, the question becomes, should he or she do so? There are a number of factors to mull over. One is that an important variable is missing from the conversion equation: future income-tax rates. As a general guideline, the Roth conversion makes sense for clients who expect to be in a higher income-tax bracket in the future, for those who are currently in the highest tax bracket and expect to remain in that tax bracket in the future, for clients with large income-tax deduction carry-forwards, and for those who expect to face estate-tax liability.
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@example.com.