Question: I would like to reduce my taxable estate but approximately two-thirds of my assets are held in a traditional IRA and the balance is held in cash.  Is there any planning I can undertake?

Answer:  Traditional Individual Retirement Accounts present estate planning challenges.  Assets held in IRAs are subject to both income tax and estate tax, the latter being incurred upon death and the former being incurred as and when IRA distributions are made.  Unlike other assets which are freely transferable, IRA funds cannot readily be transferred by gift to children or other beneficiaries without withdrawing funds from the IRA and paying income taxes on the withdrawals.

You should consider converting your traditional IRA to a Roth IRA.  Income tax will be imposed at the time of the conversion based on the fair market value of the assets held in the traditional IRA. Once converted, however, the funds in the Roth IRA are no longer subject to income tax, regardless of the growth in the account value.  Unlike the requirements for traditional IRAs, there are no required minimum distributions applicable to Roth IRAs during the owner’s lifetime; minimum distributions are only required commencing upon the owner’s death. 

Conversions of traditional IRAs to Roth IRAs are generally recommended for persons like yourself who have significant liquid assets outside of the IRA which can be used to satisfy the tax obligation upon the conversion.  However, an additional benefit of the IRA conversion in your case is the estate tax savings.  Upon the conversion of your traditional IRA to a Roth IRA, an income tax liability arises and the taxes that are paid on the conversion will no longer be part of your taxable estate.  Not only will you benefit from the conversion from an income tax perspective, but you will be decreasing your estate tax liability upon death.

You should recognize that an income tax deduction is available each year for the estate taxes attributable to post-mortem distributions from a traditional IRA. The deduction is based on the portion of the IRA funds withdrawn each year.  Since this deduction must be taken over time, the deduction is less meaningful than the immediate exclusion from your estate of the income tax liability paid upon the conversion.  Furthermore, many beneficiaries fail to take advantage of the periodic income tax deduction out of neglect.

Choosing to make a Roth IRA conversion requires a careful analysis of all of the tax consequences.  You should also consider the impact of expending a meaningful portion of your personal cash accumulation on an immediate income tax liability. Nevertheless, with your full Roth IRA account available to you on a tax-free basis for the balance of your lifetime, the conversion may be a viable planning alternative for you without forfeiting meaningful access to necessary funds.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].