A qualified distribution from a Roth IRA is not includible in a taxpayer’s gross income. A qualified distribution is a distribution that is made after the expiration of a five-year holding period, and is made:
- On or after the day that the individual taxpayer becomes 59 1/2; or,
- To a beneficiary or the estate of the owner, on or after the owner’s death; or,
- On account of the individual becoming disabled; or,
- For a qualified first-time home buyer expense.
If a deceased Roth IRA owner’s surviving spouse who is the sole beneficiary of the deceased spouse’s Roth IRA treats it as her own and has neither reached age 59 1/2, become disabled, or incurred a qualified first-time home buyer expense, a distribution from the Roth IRA to the surviving spouse will not be a qualified distribution.The entire interest in an inherited Roth IRA must be distributed:
- By the end of the fifth calendar year after the year of the owner’s death; or,
- To a designated beneficiary over a period that is not greater than that beneficiary’s life expectancy, and the distribution must begin before the end of the calendar year following the year of the owner’s death.
However, if the sole beneficiary is the decedent’s spouse, then the spouse may:
- Delay distributions until the decedent would have reached age 70 1/2; or,
- Treat the Roth IRA as his own (in which case the spouse is considered the individual for whose benefit the Roth IRA is maintained).
If the surviving spouse of a deceased Roth IRA owner treats the inherited Roth IRA as his own, then the minimum distribution rules would not apply during the surviving spouse’s life, and the post-death minimum distribution rules would apply after the spouse’s death.This article discusses when it may be advisable for the elderly owner of a traditional IRA to convert all or part of the traditional IRA to a Roth IRA. The main benefits come from preserving more of the IRA for the owner’s beneficiaries, and reducing the taxes that the beneficiaries will have to pay when the IRA is distributed to them.
While there will usually be a tax cost to such a conversion, the cost may be substantially less than the taxes the beneficiaries would have to pay when distributions from a traditional IRA are made to them.
Converting a traditional IRA to a Roth IRA over a period of years. Depending on its value, the tax cost of converting all of a traditional IRA to a Roth IRA in one year may be too high. However, if an elderly taxpayer is in good health, it may be possible to convert all or a substantial part of a traditional IRA to a Roth IRA over several years at a substantially reduced tax cost, e.g., at a rate no higher than 15 percent in each tax year. This would be especially worthwhile if the beneficiary would be taxed on distributions from a traditional IRA at a rate of at least 25 percent.
Example 1: Your client, a widow, is 72 years old, is in excellent health and expects to live at least 10 years. She lives with her son, who is a doctor in the 35 percent tax bracket. Your client has no income other than Social Security of $18,000 a year, which is based on her late husband’s earnings, $2,000 of interest on a savings account she has, and the required minimum distribution she is required to take from the traditional IRA she inherited from her husband.
The traditional IRA had a value of $100,000 at the end of 2003. In 2004, she must take a required minimum distribution of $3,953 from the traditional IRA ($100,000 divided by 25.3, the life expectancy factor from the Uniform Life Table for a person aged 72). She gives $6,000 a year to her son in payment of her share of the household expenses. She does not need the required minimum distribution she gets from her IRA, and just deposits it in her savings account.
She will pay no federal income taxes in 2004, since her gross income of $5,953 ($2,000 of interest plus required minimum distribution of $3,953) will be less than $9,150, the sum of her personal exemption ($3,100) and her standard deduction ($6,050, including the $1,200 additional standard deduction for the elderly) for 2004.
She wishes to maximize the after-tax amount that will go to her son from her IRA when she dies. If she converts $10,000 of her traditional IRA to a Roth IRA in 2004, her gross income for that year will increase to $15,953. Her taxable income will be $6,803 ($15,953, less $9,150 for the personal exemption and standard deduction). She will pay federal income tax of $680 on her taxable income for 2004 (10 percent of $6,803).
Also, the amount of your client’s required minimum distribution for 2005 will be reduced, since the $10,000 converted to a Roth IRA (and any income that would have been earned on that $10,000) will not be included in the value of the traditional IRA at the end of 2004.
For example, assume that the value of the traditional IRA at the end of 2004 would have been $105,200 if the $10,000 had not been converted to a Roth IRA, but will be only $95,000 because the conversion was made. As a result of the conversion, your client’s required minimum distribution for 2005 will be only $3,846 ($95,000 divided by 24.7, the factor for a 73-year- old individual) instead of $4,259 ($105,200 divided by 24.7).
If your client lives at least 10 years, she should be able to convert a substantial part of her traditional IRA to a Roth IRA at a tax cost of less than 10 percent of the amount converted.
On her death, her son would not have to pay income tax on any distributions from the Roth IRA to him regardless of whether the distributions are made to him over his life expectancy or the entire amount is distributed to him by the end of the fifth year after your client’s death.
Observation: Note that in Example 1, the amount converted from the Roth IRA was not enough to cause any part of your client’s Social Security income to be included in her gross income. This is because the sum of her gross income before taking Social Security into account ($15,953), plus one-half of her Social Security benefits ($9,000) is still less than $25,000, the amount at which part of the Social Security benefits would have to be included in gross income.
Consider making larger annual conversions where the client is in poor health, even if this results in paying taxes on the converted amount at a higher average rate. If an individual taxpayer is in poor health and expects to live a comparatively short time, it may be worthwhile to convert more of the Roth IRA to a traditional IRA each year, even if this means that the converted amounts will be taxed at a higher average rate. This would be especially useful if the beneficiaries still would be taxed at a higher rate on distributions from a traditional IRA inherited from the owner than the owner would be taxed at on the converted amounts.
Example 2: The same facts apply as in Example 1, except that your client is in poor health and probably won’t live beyond 2006. You advise her to convert $20,000 of her traditional IRA to a Roth IRA in 2004, and to convert similar amounts in succeeding years.
If this is done, your client’s gross income for 2004 will be $31,263 ($2,000 of interest income, plus required minimum distribution of $3,953, plus $20,000 converted from the traditional IRA to a Roth IRA, plus $5,310 of her Social Security benefits (calculated on the worksheet on page 28 of the instructions to Form 1040 for 2003). Her taxable income will be $22,113 ($31,263 less $9,150 for personal exemption and standard deduction). Her tax on this amount will be $2,967 ($700 (10 percent of $7,000) plus $2,267 (15 percent of $15,113)). In effect, the entire tax results from her conversion of $20,000 of her traditional IRA to a Roth IRA. The effective tax rate is 14.84 percent (the percentage that $2,967 is of $20,000).
If your client lives long enough to convert $20,000 of her traditional IRA to a Roth IRA in both 2005 and 2006, she will have converted $60,000 to a Roth IRA at an effective tax rate under 15 percent, and enable her son (who is in a 35 percent tax bracket) to take money out of the Roth IRA tax free.
Caution: If the amount converted from a traditional IRA to a Roth IRA causes the sum of a taxpayer’s modified AGI and one-half of the taxpayer’s Social Security benefits to exceed $25,000 ($32,000 for married taxpayers filing jointly), part of the Social Security benefits will be taxable. Thus, not only the converted amount becomes taxable, but part of the Social Security benefits also becomes taxable.
Death-bed conversions of a traditional IRA to a Roth IRA early in the tax year. For many owners of traditional IRAs, the cost of converting the traditional IRA to a Roth IRA will actually reduce the total amount that will be available to the beneficiaries. This will be especially so if the IRA owner is in the same or a higher tax bracket than the beneficiary.
However, if an IRA owner is dying early in his tax year, there may very well be a benefit to converting at least part of his traditional IRA to a Roth IRA. This is because the full amount of the personal exemption and standard deduction will be available to offset adjusted income for the tax year, even though the IRA owner is taxed only on income received before his death.
As a result of this, converted amounts that would be taxed at a rate of 25 percent or higher if the conversion were made in a year in which your client received all of his income (including Social Security benefits) from other sources for the entire year might be taxed at a lower rate if your client received only part of his annual income before he died.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
