June 24, 2011
Sometimes Congress hands out a break that is so generous it seems it must be a mistake. This one’s a doozey: The ability to receive totally tax-free inheritance of $400 million or more.
Thanks to two recent changes in the tax code, investors with huge 401(k) accounts now have a way to turn them into completely tax-free income for their grandchildren’s lifetimes.
This is by far the biggest estate-planning break on record, created even as lawmakers debate over which tax giveaways should be killed to help shore up the federal budget.
“This is a tax break you could drive 10 Mack trucks
“I call this tax break the government’s going-out-of business sale,” says IRA guru Ed Slott, who travels the country teaching advisors and accountants how to squeeze benefits out of the Roth IRA. “This is a tax break you could drive 10 Mack trucks through. It’s an incredible opportunity to do a totally tax free transfer of wealth.”
This massive estate-tax break was created last year in two steps. First, Congress lifted a $100,000 income restriction on who can convert a 401(k) or IRA to a Roth IRA, allowing even the wealthiest investors to convert. Then late in the year it raised the generation-skipping transfer tax exemption to $5 million until 2013. The GST exemption was previously $3.5 million, and was scheduled to drop to $1 million this year before Congress stepped in.
Both of these provisions on their own create possibilities for significant tax savings, upon conversion. But used in combination, the results are exponentially greater.
The Roth IRA has always been on a different playing field compared to alternatives, because it allows gains to be withdrawn tax-free. Money taken out of a 401(k), regular IRA or other retirement accounts are subject to income-tax rates. Also, the Roth doesn’t require that minimum distributions be taken after turning age 70 ½, as other plans do. So if you don’t need retirement plan assets to live on, the Roth preserves it best for heirs.
Not everyone jumps at the chance to convert to a Roth IRA, because you have to pay income taxes on the assets moved into the account. So if you plan to live off of retirement account assets, a conversion may not make sense. But from an estate planning perspective, when there are decades of gains ahead, the tax bill can be a small price to pay for big benefits down the road.
With the new GST exemption, the estate planning benefits that can be wrung out of a Roth are eye-popping. Consider an extreme case: A wealthy individual converts a large 401(k) account to a Roth IRA, and names a grandchild as the beneficiary. The grandchild, at age one, inherits the Roth, whose assets have grown to $5 million. Because of the new $5 million generation-skipping transfer tax exemption, the Roth assets would not be subject to estate tax or generation-skipping transfer tax.
Under Roth rules, an heir must take required minimum distributions, but the distributions can be stretched over a lifetime and assets left in the Roth can continue to grow tax free. Based on a one-year-old’s 81.6-year life expectancy, assuming an average annual return of 8%, Slott calculates that the grandchild’s lifetime income from the Roth would be $408 million – “completely free of estate, gift, income and capital gains taxes,” he says.
With a $5 million exemption, the Roth has become a turbo-
charged tax-favored inheritance tool.
If both grandparents left a big Roth account to the same grandchild, the tax-free inheritance would be almost twice that amount, depending on the age of the grandchild when the second Roth is inherited.
You don’t have to have stratospheric wealth to get in on these great estate planning benefits. Making the same assumptions about life span and returns, a modest $100,000 Roth inheritance would let a grandchild pocket more than $8 million, tax free. This would have been possible even under the old GST tax exclusion, but the old Roth rules, which prohibited conversions from IRAs and 401(k)s for those with incomes above $100,000, would have prevented many from taking advantage of the opportunity.
With a new $5 million estate tax exemption, passed along with the GST exemption last year, the Roth has become a turbo-charged tax-favored inheritance tool for any generation. But the benefits are even more pronounced when the Roth income is spread over the long expected lifetime of a grandchild.
Grace Allison, senior vice president and tax strategist at Northern Trust, cautions that the up front tax bill on Roth conversions can take the shine off of this strategy, so it’s critical to crunch the numbers. If you convert $5 million, at the highest tax rate of 35 percent, you’ll have to hand over about $1.7 million.
That kind of tax bill is mind-numbing for most people, but in the universe where ultra wealthy people are trying to preserve their multi- millions, $1.7 million may seem like a small amount to pay considering for how much will be saved in taxes in the long run. In the extreme example above, the total tax savings would be in the neighborhood of $100 million over the grandchild’s lifetime, probably much more
Did Congress intend for this big generational benefit? While the government could surely use wealthy taxpayers to pay big up-front tax bills on Roth conversions right now, the amount it would forgo in taxes on inherited money over decades would be staggering.
Whether intentional or not, opportunities to combine the Roth with the GST exemption are limited: The exemption is scheduled to drop to $1 million in 2013.
And it’s always possible that tax reforms will rescind these tax breaks before that. Roberton Williams, senior fellow at the Urban Institute, says that if any drastic changes are made, it will be Congress’s mess to figure out how to honor previous tax breaks in Roth accounts. In the meantime, get ‘em while you can.
Looney Loopholes: 5 Tax Breaks that Boggle the Mind (The Fiscal Times)
Longtime Tax Breaks May Get Booted by the Budget (The Fiscal Times)
Budget Reform Math: Tax Breaks = Government Spending (The Fiscal Times)