Should you convert your taxable retirement account to a tax-free Roth individual retirement account and how should you deal with the uncertainty over the estate tax?
ROTH CONVERSION Starting in 2010, there will no longer be an income limit for Roth I.R.A.’s, which allow people to contribute post-tax money that can appreciate tax-free. The income limit has been $100,000 a year for individuals. The question is whether converting an existing I.R.A., the proceeds of which are taxed when distributed, into a tax-free Roth I.R.A. makes sense. While Congress approved the change in 2006, the opportunity to convert seems to come at an enticing time. Those whose pretax retirement accounts lost a lot of their value in the last two years might want to withdraw the money, pay tax on the amount and then put it into a Roth. For wealthy investors who do not see themselves falling into a lower income tax bracket at retirement or who believe tax rates will rise significantly, this could be a shrewd move.
The bigger benefit may come to people who plan to pass their Roth on to heirs. Unlike regular retirement accounts, there is no minimum distribution requirement with a Roth, and the tax-free treatment of its assets can be passed to an heir.
ESTATE TAX The elephant in the room is the estate tax. Congress has adjourned for the year without making any changes in that tax law. So as of now, that means the tax will disappear in 2010 before reverting in 2011 to the old rate of 55 percent for estates worth more than $1 million.
But there is a broader issue. When a person dies now, the value of his or her assets gets a “step-up in basis,” which means for tax purposes the assets are valued on the day of death. Without an estate tax, this provision disappears, and the appreciated value is subject to capital gains tax.
The Internal Revenue Service will grant a $1.3 million “artificial basis” on assets of a single person and $3 million for couples if the estate tax disappears. But on the rest of the assets, the heirs will have to determine what the original cost was and pay the capital gains on the appreciated amount. For long-held stock that has split many times, this could be extremely difficult.
Still, most advisers and accountants expect that an estate tax will be reinstated, and this has pushed tax payers to find new ways to reduce its impact. One way is through giving money to heirs above the $1 million lifetime exemption level and paying the 45 percent gift tax now. This may seem odd at first, since the estate tax is currently the same rate. But the benefit comes from how the taxes are applied:the gift tax is added like sales tax, while the estate tax is deducted like income tax. A person with a $30 million estate could give roughly $20 million to his heirs during his lifetime and pay $10 million in gift taxes, or he could leave the $30 million to them and they would receive $15 million, after estate taxes.
An option to avoid gift and estate taxes is to lend money to heirs. The Internal Revenue Service rate for such intrafamily loans in December is 0.69 percent for up to three years. The money the child makes investing above the I.R.S. rate is not subject to the higher 45 percent gift tax, but instead the lower 15 percent capital gains tax. If you die before the loan is repaid, however, the outstanding balance could be subject to income tax.
GIFT TAX EXCLUSION One of the most basic but highly effective estate tax strategies is the annual gift tax exclusion. The I.R.S. in 2009 allowed people to give up to $13,000 a year to anyone they wanted, tax-free. (This exclusion is separate from the $1 million lifetime exemption.) But this is something that many people overlook. However for those with an estate subject to a 45 percent estate tax, each $13,000 gift will save them at least $5,520 in estate tax.