Pennsylvania Trusts and Estates Blog

An inherited Roth IRA is truly a "gift that keeps on giving." It is an exceptional estate planning tool.

When deciding whether or not to convert your traditional IRA to a Roth IRA, most people (or their advisors) "run the numbers." The cost and benefits of a Roth conversion is compared to the status quo - maintaining the traditional IRA. Assumptions are made about investment returns, future income tax rates, life expectancy, etc.

In most cases, using reasonable assumptions, the Roth IRA conversion usually looks like the better choice, although the psychological hurdle of paying a big income tax bill now still prevents many IRA owners from doing the conversion. (Maybe it's not just psychological - I suppose income taxes could be lower in the future, although that seems to conflict with the reality principle.)

If the beneficiaries intend to liquidate the IRA right away and spend it, the calculation might be close. But transferring a Roth IRA to your beneficiaries on your death can be a VERY valuable opportunity, if they do not miss it. If the beneficiaries, instead of withdrawing the Roth IRA immediately, maintain the Roth IRA as an inherited IRA and take the minimum required distributions over their life expectancies, then they are getting a terrific benefit.

A person who inherits a Roth - unlike the original owner of the account - is required to take a minimum required distribution each year, beginning in the year following the year of death. The beneficiary must withdraw a percentage of the funds annually, based on his/her age. Comparing the traditional IRA against the Roth IRA for the lifetime of the owner and his/her spouse is not enough. To understand what it means to a beneficiary to inherit a Roth IRA, the projections have to keep going.

The beneficiary has an asset which will grow at a compounded rate tax-free for his/her lifetime and any withdrawals made will be completely tax free. There is simply nothing else like it. No other investment will give this kind of return tax-free. Inheriting a Roth IRA is much more valuable than inheriting any other asset. Any other asset - whether it be stocks and bonds, real estate or cash - will be subject to income tax on its income and growth. Traditional IRA distributions will be subject to income tax.

The younger the beneficiary is when the IRA is inherited, the longer the beneficiary can stretch out withdrawals, giving more time for tax-free compounded growth of the investments inside the Roth. The beneficiary's inheritance could get bigger as he or she gets older. It is like giving your beneficiary a tax-free, lifetime annuity.

Since younger beneficiaries with a longer opportunity for stretching out distributions get the most benefit, consider naming grandchildren as your Roth IRA beneficiaries. If you are concerned about leaving a substantial sum to young children, there are solutions. You can name a Custodian under the Uniform Transfer to Minors Act (UTMA) to receive distributions, and then the custodian can accumulate the withdrawals and use them as needed for the child until the child is 21. If you set up a trust as a beneficiary for the benefit of the minor child, the trustee can hold the accumulated distributions until the beneficiary reaches more mature years - age 30, 35 or any other age you would like to specify. For a trust to be able to be used with the stretch-out of distribution, the trust must be carefully drafted to comply with complex IRS rules.

If you cannot bring yourself to pay the current income tax required to convert your traditional IRA to a Roth, and you have reason to believe your life expectancy is limited, then do the Roth conversion in anticipation of death. The income tax due as a result of the conversion will be paid by your executor as a debt of your estate and will be deductible for inheritance and estate tax purposes. Your beneficiaries will get the benefit of inheriting a Roth IRA - the best asset to inherit.

When the Roth IRA conversion law was enacted in 1997, taxpayers with adjusted gross incomes over $100,000 could not convert. No more. On January 1, 2010, every IRA owner will qualify for a Roth IRA conversion - there will be no income limitation.

When a traditional IRA is converted to a Roth, all before-tax contributions made to the IRA become taxable. But once the money is in the Roth IRA, it grows tax-free; and you can make tax-free withdrawals at any time provided that five years has passed. For a Roth IRA, there are no minimum required distributions after you attain age 70-1/2.

For Roth conversions in 2010, there is an additional benefit. The amount withdrawn does not have to be reported as part of your 2010 income. One-half can be added to income in 2011 and one-half in 2012. Conversions in 2011 and thereafter are included in income during the tax year in which the conversion is completed.

Since most IRAs took a beating in the market in 2007 and 2008 and still haven't recovered, the taxes on a conversion will be less than they could have been. Even if the additional income due to the conversion pushes you into a higher tax bracket, it may be worth it if you would have to pay higher taxes on later minimum required distributions or if income tax rates go up. If income rates go up in the future, tax-free Roth IRA income will be more valuable.

Roth conversion is not all or nothing. You may choose to convert part of your traditional IRA to a Roth (although if you have multiple IRAs you must convert each of them proportionally).
If you convert and then decide you made a mistake, you have until October 15 of the year following the year of the conversion to recharacterize and go back to a traditional IRA.

Should you convert to a Roth? The short answer is that if you can afford to pay the tax out of non-IRA assets, you are unlikely to be hurt and may do very well. So go ahead and convert. If you need to make additional withdrawals from the IRA in order to pay the taxes on the conversion, don't do it. The money you have to withdraw to pay the tax will be subject to income tax and penalties, and it will be gone - in the government's coffers - not compounding tax-free in your Roth.

The question is more than can you "afford" to pay the tax out of non-IRA assets. It's also, do you "want" to pay the taxes. Many people have a psychological aversion to paying any tax a minute before they absolutely have to. And in truth, many of these people have been proven correct. As we know, the tax law changes all the time. Wouldn't it make you feel silly to have paid the tax on a Roth conversion and 15 years from now find that the law is changed in such a way that no tax on your IRA would ever be due?

The long answer is that you must consider a number of factors: the value of the IRA, the tax rate on conversion, when you think withdrawals will be needed, when you plan to retire, what your age and health is, what future income tax rates will be (that is a huge unknown) and other imponderables. Then do projections based on these variables and different assumed rates of return. Lots of planners will make money trying to crunch these numbers using software to generate and sell reports consisting of pages and pages of projections. My advice: skip all that and go back to the short answer.

If you want to convert to a Roth, do it as early as possible in 2010 on the theory that the assets may grow as the market recovers and the sooner you convert, the less the tax will be. It makes sense to start planning for the transaction now. Let the custodian of your IRA, the bank, mutual fund company, or other financial institution that holds your account know your intentions. Ask for the proper forms if they are already available, decide how you want your converted assets invested, determine whether you will pay the taxes in 2010 or take the 2-year deferment deal, decide whether you will pay the taxes yourself or whether you want the custodian to withhold taxes, and name a beneficiary for the Roth on your death.

The opportunity to have assets grow tax-free inside the Roth and be withdrawn with no tax is a valuable one. Albert Einstein said "The most powerful force in the universe is compound interest." He was close, but not quite right. The most powerful force in the universe is the tax-free compounding of interest.

Entrust Group launched a new service for IRA owners. Now you can access your IRA with the swipe of a debit card.  Want that new pair of shoes -  go ahead -  use your IRA money.  Want to go on vacation - use your IRA.

This is the worst idea I have heard in a long time.  Phyllis Furman, writing for the Daily News:"The IRA Card is the new and improved way to access your Individual Retirement Account," said Entrust CEO Hugh Bromma.

"It's just like any other debit card. You can use it at a store, restaurant or travel agency."

But critics of products like the IRA Card and 401(k) cards warn they can be dangerous because they allow you to quickly tap into funds that should be locked away and growing for your retirement.

"Retirement money is to be used for retirement," said John Graziano, a CPA with Future Financial Planners in Bayonne, N.J. " 

If you use your IRA debit card, not only do you spend your retirement savings, but you have to pay income tax on the amount withdrawn and, if you are under 59-1/2, pay a 10% premature distribution penalty. 

This is a product option to which we recommend you "Just Say No."

 Blogging credit to Neil Hendershot.

You don't have to take a required minimum distribution (RMD) from your IRA in 2009.

Under the Worker, Retiree, and Employer Recovery Act of 2008 (WRERA) signed by President Bush on December 23, 2008, RMDs for IRAs and other qualified defined contribution plans are suspended. It is a one year waiver for 2009 only.

This is welcome news to retirees who are looking at accounts whose values have steeply declined. The amount required to be withdrawn is determined by reference to the account value at the beginning of the year. When investment values decline sharply, a RMD taken later in the year takes a bigger chunk of the balance in the IRA.

IRA owners and beneficiaries may not want to withdraw assets from retirement accounts at this time because they may need to sell stocks and bonds at a depressed price in order to access their funds. The hope is that the market will rebound by 2010, at which time it would be more logical to sell the stocks and bonds to meet the RMDs.

Many hoped that relief would be granted for 2008 since the 40% stock market decline occurred during calendar 2008. However, WRERA does not provide any relief for 2008 RMDs. This is very unfortunate. Apparently Congress thought the implementation of such a late change in the tax law wouldn't work. For some taxpayers, the ability to skip a year will make up the loss. Of course, that assumes you can afford not to take your RMD - which cannot be assumed. WRERA does not provide relief for those persons who actually need to use their IRAs and retirement accounts for their support - in these cases the individuals will still take distributions regardless of the suspension of the RMD rules.

Consequently, the primary beneficiaries of the RMD relief rules of WRERA are those account owners and beneficiaries who have sufficient other income or assets so that they do not need to take any withdrawals from their retirement accounts.

There is talk that when Congress reconvenes in January that there still might be some relief for 2008, but a waiver of the RMD for 2008 looks very unlikely.

IRA owners are required to take a minimum annual amount out of any traditional IRAs beginning in the year when they reach 70 ½ years of age, or no later than April 1 of the following year. For example, if you turn 70-1/2 in 2009, you would normally be required to take your first RMD by April 1, 2010.

The RMD is calculated based on the owner's age (older folks must take out more) and the IRA balance at the end of the previous year. The RMD provision also applies to traditional 401(k)s but not to an individual's own Roth IRAs or Roth 401(k)s. Roth IRA distributions are not taxable. Failure to make a RMD triggers a 50% penalty tax calculated against the RMD that should have been distributed in that particular year.

You must also take RMDs if you are a beneficiary of a decedent's IRA, 401(k) or other retirement account, because when the account owner dies, regardless of age, you must begin taking RMDs. This is also true if you are the beneficiary of a Roth IRA, even though Roth IRA owners are never required to take RMDs.

Normally, people who reach age 70½ in 2009, and who wait until April 2010 to take their first withdrawal, would have to take two distributions in 2010: one for 2009 (their first distribution) and one for 2010 (their second distribution). That second distribution would have to be taken by Dec. 31, 2010.

Since the new law suspends distributions for 2009, first-timers -- anyone who turns 70½ in 2009 -- won't be required to make a 2009 withdrawal, which normally would not have to take place until April 1, 2010. But he or she will need to make the 2010 withdrawal, and that will be considered your "second" distribution, even though in reality it will be your first withdrawal. Therefore you'll have to take it by Dec. 31, 2010. (Individuals who turn 70½ in 2009 will not be able to wait until April 1, 2011 to take their first withdrawal.)

For beneficiaries of inherited IRA's who are taking the money out under the five year rule, you can stretch your five-year deadline out by another year.

These provisions provide relief to participants in and beneficiaries of IRAs, SEP-IRAs, SIMPLE IRAs, 401(k) plans, money-purchase plans and profit-sharing plans. WRERA does NOT apply to defined benefit plans.

Another provision added by WRERA is that qualified plans will be required to allow non-spousal beneficiary rollovers to inherited IRAs effective in 2010 (this provision is currently optional and the vast majority of plans have not offered the option).

In view of the precipitous decline in the stock market, there are some tax strategies for owners of traditional or Roth IRAs to consider.

Converting a traditional IRA to a Roth IRA

A traditional IRA can be converted to a Roth IRA if, for the conversion year, (1) the taxpayer's modified AGI (not counting the taxable amount of the conversion) does not exceed $100,000, and (2) the taxpayer's not a married individual filing a separate return (unless he lived apart from his spouse during the entire withdrawal year). The amount withdrawn from the traditional IRA and put in the Roth IRA is 100% taxable as ordinary income in the year of the conversion. The 10% penalty for premature withdrawals before age 59-1/2 does not apply.

If your traditional IRA has declined in value because of the current stock market debacle, and you otherwise qualify; now would be a great time to do a Roth conversion while its value is low and, thus, the amount subject to income tax would be low.

The advantage of a Roth IRA is that, if you qualify, the entire value of the account plus its earnings are income tax free when you or your beneficiary withdraw them. Plus there are no requirements to take minimum distributions beginning at age 70-1/2. The Roth IRA can continue to grow tax-free.

Recharacterizing an Underwater Roth Conversion

If you converted a traditional IRA to a Roth IRA ealier this year when the market was much higher, you can treat the conversion as if it never happend by recharacterizing it. Transfer the amount converted to the Roth IRA (plus earnings or minus losses) back to a traditional IRA by a trustee-to-trustee transfer.

Here's an example: You converted a traditional IRA to a Roth IRA in February 2008 when it was worth $40,000. Currently, the Roth IRA is worth only $25,000 due to market decline. To avoid paying tax on $15,000 ($40,000-$25,000) of evaporated or phantom income, you can recharacterize the Roth IRA back to a traditional IRA.

How do you recharacterize? You must do two things: (1) Contact the financial institution that administers your IRA and have them make a direct transfer from the Roth back to a traditional IRA. The transfer to the traditional IRA is treated as if it were the original recipient of the rollover, so the tax consequences of the initial conversion to the Roth IRA are avoided (i.e., the taxpayer does not recognize the income that would have been recognized with the initial Roth conversion). Note that the transfer must include the earnings (or losses) allocable to the converted amount. You cannot withdraw funds from a ROTH and redeposit them to a traditional IRA - that won't work. The transfer has to be trustee-to-trustee. (2) The easiest way to make a recharacterization of a 2008 conversion is to reflect it on your 2008 Form 1040 due on or before April 15, 2009 (or Oct. 15, 2009, if the taxpayer gets an automatic extension of six months to file his 2008 return). However, a taxpayer who timely files his 2008 return without having recharacterized a 2008 conversion may do so as late as six months after the original due date for filing the 2008 return, i.e., by Oct. 15, 2009. If a 2008 conversion is recharacterized after the taxpayer timely files his 2008 return, he should file an amended return for 2008 reflecting the recharacterization (the notation "Filed pursuant to section 301.9100-2" should be made on the return).

Going back to a Roth Again

Since you wanted a Roth IRA in the first place and only recharacterized back to a traditional IRA becuase of the market decline and the evaporated taxable income, when can you go back to a Roth again? The reconversion cannot be made before the later of (1) the beginning of the tax year following the tax year in which the amount was converted to a Roth IRA (January 1, 2009 for 2008 conversions) or (2) the end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by way of a recharacterization. It is best to go back to Roth when the market is low to minimize the tax impact.

Remember, PA treats IRAs completely differently than the feds. There is no PA deduction for contributions to a traditional IRA. Earnings in an IRA account are not subject to tax if withdrawals are taken from the IRA as retirement benefits. If premature withdrawals are taken from an IRA, PA taxes the withdrawals to the extent they were not previously taxed (e.g. on account earnings since contributions were previously taxed). No PA tax is due on a Roth recharacterization.

On October 3, President Bush signed into law the Emergency Economic Stabilization Act of 2008, more commonly known as the "Bailout Bill." The financial bailout provisions have had the headlines for days as everyone tries to sort out what on earth the legislation actually does. But the bill also includes a raft of other tax changes (most added by special interests) that affect individuals, corporations, and businesses. Here are some examples:

1. Alternative Minimum Tax (AMT). The legislation includes the 2008 AMT Extenders Act. The AMT exemption for individuals is raised for 2008;$46,200 for singles, $69,950 for married couples, and $34,975 for married couples filing separately. This is a one-year "patch." The Act also liberalizes the AMT refundable credit for individuals with long-term unused minimum tax credits. We hope that the need to reform the AMT tax will be a high priority for the new administration.

2. Extended Tax Breaks. More than 30 tax breaks that either expired at the end of 2007 or will expire soon have been extended by the Act. For individuals, extenders went into effect for the election to deduct state and local general sales tax, the $250 above-the-line deduction for teachers out-of-pocket classroom-related expenses (extended through 2010), and the ability of taxpayers age 70 ½ or older to make nontaxable IRA transfers to eligible charities.

The Pension Protection act of 2006 had amended the IRA distribution rules to allow a tax-free distribution from an IRA owned by a person over age 70-1/2 of up to $100,000 directly to charities. This "charitable rollover" was available in 2006 and 2007. The Act makes it available for 2008 and 2009.

The Housing Assistance Tax Act of 2008 provided a real property tax deduction for non-itemizers. The real property tax deduction is added to the standard deduction up to $500 ($1,000 for a joint return). The Act extends this additional deduction to 2009.

For businesses the following are examples of provisions that were extended: the research credit, the 15-year writeoff for qualified leasehold improvements and qualified restaurant property, enhanced deductions for certain charitable contributions, and the expanding option for qualified environmental remediation expenses.

3. New Tax Relief Measures. There are relaxed write-off rules for film and TV productions, quick 5-year depreciation for many types of farm property, modified rules for the penalty on understatement of a taxpayer's liability by a tax return preparer, mental health parity rules, and liberalized rules for the refundable child tax credit.

4. Energy Incentives. Extensions were enacted for the alternative energy credit, the residential energy efficient property credit, the energy efficient buildings deduction, the credit for energy efficient improvements to new homes, and a new credit for plug-in electric vehicles. Many other tax incentives for alternative energy creation are either extended or created.

5. Disaster Relief. The Act provides a raft of tax relief measures for disaster victims in ten Midwestern states (Arkansas, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, and Wisconsin) and also creates new national disaster relief for all federally declared disasters occurring after 2007 and before 2010. These provisions include expanded loss deduction rules for individuals, fast writeoffs for business cleanup expenses, and a 5-year carryback for NOLs attributable to qualified disaster expenses.

6. Revenue Raisers. The revenue raisers in the Act include broker reporting of customers' basis in securities transactions, an extension of the 0.2% FUTA surcharge, a limited domestic production activities deduction for the oil and gas industry, and new rules for certain nonqualified deferred compensation.

Congress believes (and they are probably correct) that there is significant under-reporting of capital gain income as a result of taxpayers misreporting cost basis. Brokers now will have to track and report the basis for "covered securities" which are securities acquired through a transaction in the account in which the security is held or transferred to the account from another account where they were covered securities. Securities acquired by gift or inheritance are not covered securities. The method will be first-in first-out (FIFO) unless the customer notifies the broker of a different identification of the stock to be sold.

7. Wooden Arrows. Oh, yes - a very important provision: the Act exempts from excise tax certain wooden arrows designed for use by children. Current law places a 39 cent excise tax on the manufacturer, producer or importer of "any shaft consisting of all natural wood with no laminations or artificial means to enhance the spine of the shaft used in the manufacture of an arrow that measures 5/16 of an inch or less and is unsuited for use with a bow with a peak draw weight of 30 pounds or more." Oregon Senators Ron Wyden and Gordon Smith were the initial sponsors of the provision. According to Bloomberg News, the provision would be worth $200,000 to Rose City Archery in Myrtle Point, Oregon.

For more examples of what the special interests did to his legislation see Have Some Tax Pork by Professor James Edward Maule at Mauled Again.

The "Bailout" which is what the public calls The Emergency Economic Stabilization Act of 2008 (H.R. 1424) passed the House and was signed by President Bush on October 3, 2008.  Lot and lots of little "additions" appeared - plus lots of "pork."

Good news for charities - the law extends the IRA Charitable Rollover which allows individuals who are over age 70 to transfer up to $100,000 per year to charities form their IRAs.  It is now applicable for 2008 and 2009.

The charitable rollover is available only for outright gifts to charities, not split interest gifts like charitable remainder trusts. There are four requirements: (1) the IRA gift must otherwise have been includible ordinary income to the IRA owner, (2) the IRA owner must be 70 ½ or older, (3) the gift must be to a qualified exempt public charity, and (4) the recipient may not be a private foundation, supporting organization or donor advised fund.

Blogging credit to the North Carolina Estate Planning Blog

More to the point - do you have more than one IRA at Vanguard? About a year ago, in July 2007, Vanguard Group sent 170,000 customers a form letter titled "Change in beneficiary policy will help you simplify your planning." What it really meant, as reported by Ashlea Ebeling writing for Forbes, is: "Warning! Unless you act, we're about to change who gets your Individual Retirement Accounts when you die."

Vanguard decided that customers must use identical beneficiaries for all IRAs of the same type. All your IRAs holding money rolled from employer pension plans count as the same type and must have the same beneficiaries. Traditional IRAs, both pretax and aftertax, are a second type. Roth IRAs are a third.

There are all sorts of reasons one might want to have multiple IRAs. One could be for your wife, another for the children of your first marriage. You might want one for each child. One might be payable to a trust, another to your children outright. None of this is allowed anymore at Vanguard. If you have named beneficiaries that are not the same for each account of the same type - it has now been changed. What you designated will not apply. Vanguard has changed your beneficiaries. Isn't that shocking?

If you had multiple IRAs which beneficiary designation did they pick? Vanguard will apply the newest beneficiary form to all your IRAs of one type. If two forms were submitted at the same time, Vanguard will treat the one it processed later as newer.

If you have Vanguard IRAs you must be in contact with them to see who your named beneficiaries are. You can change the beneficiary, as long as all IRAs of the same type have the same beneficiary.

For many folks, their IRA is the largest asset in their estate. The provisions of a will do not govern who gets the IRA - it goes by its beneficiary designation.

Vanguard's unilateral action is wreaking havoc with many estate plans. Many financial planners and estate planning attorneys recommend that their clients divide IRAs. For example, since an IRA is an excellent asset to leave to charity (because the charity can receive it free of income and estate tax); it is common to put a part of an IRA in a separate account with a charitable beneficiary. This is important because there are some complex rules and traps to be avoided if a charity is one of a group of beneficiaries.

I thought the policy change to be so misguided and shocking - and it received such bad press - that surely Vanguard would reverse its policy and go back to sanity. But no, here it is a year later, and they are holding fast.

Ebeling's Forbes article states: "Say you've named your older child primary beneficiary of one rollover IRA and your younger child primary beneficiary of another. If you don't read your mail carefully, or were on vacation or in the hospital when the letter came, and you die without contacting Vanguard, one of your kids could be done out of his IRA inheritance." When Forbes showed Vanguard's letter to IRA experts, they were outraged. "This borders on the unconscionable," fumed Green Bay CPA Robert Keebler. "It's crazy. I don't see how they can change the beneficiaries on your accounts without your consent,'' said Boston lawyer Natalie Choate.

Dan Caplinger writing for The Motley Fool advises, "Don't let your broker or fund company have the final word on how you plan your estate. If your provider won't follow your instructions, make a change and find one that will. You deserve to keep control of who'll inherit your assets."

Vanguard doesn't usually get bad press. Finance reporters really like its low-cost, customer friendly approach. But they got this one wrong. If Vanguard won't let you name the beneficiaries you want - go elsewhere.