By Stephen P. Magowan

The Roth IRA is perhaps the best piece of "relief" in the Taxpayer Relief Act of 1997 (TRA 97). A Roth IRA differs from a traditional IRA in many respects, most importantly in that contributions to a Roth IRA are not tax deductible and that qualified distributions from a Roth IRA are not taxable to the recipient. In creating the Roth IRA, Congress gave taxpayers within a certain income range the opportunity to convert traditional IRAs to Roth IRAs but, in such a conversion, taxpayers must pay income tax on the full value of the traditional IRA, generally for the year of conversion. Accordingly, clients considering a conversion must determine whether the Roth IRA benefits of tax-free qualified distributions and lack of required minimum distributions outweigh the tax triggered by the conversion. The conversion question is more compelling in 1998 because, as described below, Congress created an income tax incentive for 1998 conversions.

A consensus appears to have emerged among financial advisers and the popular press that taxpayers who are younger than age 50 are the most likely to benefit from converting a traditional IRA to a Roth IRA. In at least three situations, however, a client over age 50 should consider converting his or her traditional IRA to a Roth IRA as a way to save estate taxes and create increased estate planning flexibility. These situations most generally will occur when:

• a client has passed his or her required beginning date (RBD) but has failed to designate a beneficiary for his or her traditional IRA;
• a client's designated beneficiary, usually a spouse, has died after the client has passed his or her RBD; or
• a spouse has inherited a traditional IRA and will have a taxable estate.

  This article examines when a client should consider converting a traditional IRA to a Roth IRA, even though the holder would not generally benefit from such a conversion, and demonstrates that a conversion to a Roth IRA offers an excellent planning opportunity for elderly clients with large IRA assets to move their IRA assets to their descendants in a tax-efficient manner.

  Differences Between Roth IRAs and Traditional IRAs
  The key differences between a Roth IRA and a traditional IRA are:

• Contributions to a Roth IRA are not tax deductible, regardless of the account owner's income.
• Distributions from a Roth IRA are not taxed if the owner keeps the funds in the IRA for the period required under the statute and if the owner takes only "qualified distributions" from the IRA.

  Code 408A(d). The maximum contribution to all Roth IRAs and traditional IRAs a person with compensation income can make for any taxable year is $2,000. Code 408A(c)(2). A person can mix and match contributions, however, such as $1,000 to a traditional IRA and $1,000 to a Roth IRA. Congress phased out the $2,000 amount for married couples filing joint returns with incomes from $150,000 to $160,000 and for single filers with incomes from $95,000 to $110,000. No additional restrictions apply to persons who participate in tax-qualified retirement plans. Thus, if a Roth IRA owner and his or her spouse jointly earn $130,000 a year and are both active participants in a qualified plan, they could each contribute $2,000 to a Roth IRA.These Roth IRA rules differ significantly from traditional IRA rules. A person can deduct a contribution to a traditional IRA if he or she does not participate in a tax-qualified plan or if he or she participates in a tax-qualified plan and his or her income does not exceed certain levels. The precise nature of these rules is not critical to this article and will not be examined further.

  Roth IRA Distribution Rules
  Two key general rules govern distributions from a Roth IRA. First, the Code  401(a)(9) minimum distribution rules do not apply to the owner of the Roth IRA. Accordingly, the owner need not take distributions from the IRA beginning on April 1 of the calendar year following the year he or she reaches age 70 1/2. The minimum distribution rules only apply to a Roth IRA after the owner dies, and even then they can be postponed by a spouse (but no other beneficiary) who inherits the Roth IRA and elects to treat it as his or her own.

  Second, the Roth IRA owner or his or her successors pay no federal income tax on a "qualified distribution." A "qualified distribution" is any payment or distribution:

• made on or after the date on which the owner reaches age 59 1/2;
• made to a beneficiary (or to the estate of the owner) on or after the death of the owner;
• attributable to the owner being disabled; or
• that is a qualified "special purpose distribution." Code 408A(d)(2). Under these rules, a beneficiary, such as a spouse, child or grandchild, will pay no federal income tax on distributions from the Roth IRA after the owner's death.

  A payment or distribution is not a qualified distribution if made within the five taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA. Note, however, that the Code treats the owner as having withdrawn his or her contributions_which were already taxed_first on a "first-in, first-out" approach. Code 408A(d)(1)(B). Thus, the owner of a Roth IRA who has contributed $10,000 to the IRA can always withdraw up to that amount tax free.

  Problems with Estate Planning for Traditional IRAs
  

  A traditional IRA often complicates estate planning, primarily because a traditional IRA is an item of income in respect of a decedent (IRD). As a result, the assets of the IRA are subject to both estate tax and income tax on the owner's death. How does this happen? Assume, for example, that a client leaves 100 shares of Bigco stock to her daughter. The client bought these shares for a total of $1 per share, and the client's total basis in the shares equals $100. Assume also that at the client's death the shares are trading at $100 per share, and that the daughter sold all of the shares for $10,000 six months after the client died. Under income tax rules, the daughter's basis for calculating gain on the sale would be the value of the shares at client's death, i.e., $100 times 100 or $10,000. Code  1014. Thus, the daughter would have paid no income tax when she sold the shares in the above example. If the daughter sold the shares for $110 per share, she would pay capital gains tax on the difference between $110 and $100, or $10, multiplied by the number of shares sold.

  Assets in a traditional IRA, however, do not enjoy the benefit of a new basis on the owner's death. Assume that instead of leaving Bigco shares to her daughter, the client left a $10,000 traditional IRA to her daughter and that six months after the client's death, the daughter withdrew all the funds from the traditional IRA to pay for funeral and related expenses. In this instance, the daughter would have to pay income tax on the full $10,000 at ordinary income tax rates. The daughter may have the benefit of an income tax deduction equal to the amount by which the inclusion of the IRA assets in her mother's estate increased the federal estate tax on the estate. Code 691(c). Because this is an income tax deduction and not a tax credit, it will not reduce the income tax dollar-for-dollar for each estate tax dollar paid. Thus, the assets passing from a traditional IRA to the owner's beneficiary are subject to both estate and income tax. As a result, the ultimate amount passing to the owner's beneficiary will be greatly reduced because the estate tax is as high as 55% and the federal income tax is as high as 39.6%. State death taxes and income taxes may further increase the tax burden.

  Benefits of the Roth IRA in Estate Planning
  

  A Roth IRA is very different from a traditional IRA because no federal income tax applies to "qualifying distributions" from a Roth IRA. Thus, after the owner's death, the assets of his or her Roth IRA will be subject only to estate tax, not income tax. This places Roth IRA assets on the same playing field as capital assets. In fact, the Roth IRA is superior to a capital asset because the post-death appreciation in the Roth IRA is never subject to income tax, while post-death appreciation in a capital asset is subject to federal income tax on the sale of the asset.

  Consider the previous example. If the Bigco stock doubles to $20,000, the daughter will have to pay tax on a $10,000 capital gain if she sells the stock. If, however, the traditional IRA were a Roth IRA, and if the Roth IRA assets doubled to $20,000, the daughter would pay no income taxes if she sold the assets and liquidated the account.This income tax exemption is very valuable. For example, assume that a client leaves a $100,000 Roth IRA to a 27 year old beneficiary. Assume also that the IRA earns a total return of 8% free of income tax, that all distributions from the IRA earn an after-tax total return of 5.76% and that the 27 year old lives until age 83. When the beneficiary reaches age 83, the Roth IRA assets, plus the after-tax investment account, would equal $4,744,471. Using the same assumptions, a traditional IRA, plus the after-tax investment account, would be worth about $2 million less because the distributions to the beneficiary would be taxable when he or she received them, and these taxes would increase as his or her minimum required distributions increased.

  These differences become even more remarkable when the analysis uses younger beneficiaries and larger account numbers. A Roth IRA of $150,000 left to a seven year old beneficiary, under the same earnings and investment assumptions, would be worth over $25 million when the beneficiary reached age 83. A $150,000 traditional IRA for the same seven year old would be worth "only" about $14 million when the beneficiary reached age 83 because, as the beneficiary's minimum required distributions increased, the income taxes on those distributions would go up.

  Although these examples may be extreme, they show that at any given point, amounts sitting in a Roth IRA are available for college expenses, housing costs and other qualified expenses on a tax-free basis. Thus $20,000 in a Roth IRA buys $20,000 worth of educational expense, not some other after-tax amount.

  Conversion of Traditional IRAs
  One way out of the conundrum posed by the IRD rules for a client with a large traditional IRA is to convert it to a Roth IRA. When the client makes the conversion, income tax will result. For instance, if a client converts a $100,000 traditional IRA to a Roth IRA, he or she would have to pay income tax on $100,000.

  Not all clients can convert traditional IRAs to Roth IRAs. Only clients whose adjusted gross income for the taxable year of a conversion is $100,000 or less can make the conversion. The income from the conversion does not count in determining the limit. Further, a married client who files a separate return may not make a rollover contribution. Rollover contributions are not subject to the 10% excise tax of Code 72(t) or the $2,000 annual limitation on contributions to a Roth IRA. Moreover, TRA 97 has another benefit for eligible taxpayers making the conversion in 1998. For rollovers in calendar year 1998, any amount required to be included in gross income is included ratably over the four taxable year period (i.e., one quarter is included each year) beginning with the taxable year in which the payment or distribution is made. As a result, clients can defer paying the tax on the traditional IRA without paying any interest on the deferred tax.

  The Planning Opportunity
  Estate planning lawyers should review the possibility of converting a traditional IRA to a Roth IRA with many of their elderly clients. In particular, lawyers should pay attention to single clients who have their own IRAs with significant assets. In many instances these clients will have named a spouse as primary beneficiary and elected to recalculate life expectancies to determine their required minimum distributions. For these clients, the potential for a high amount of estate and income tax after death is significant.

  To understand the planning possibilities, consider the following example. A 77 year old client owns a $600,000 traditional IRA and $600,000 in other estate taxable assets. The client's spouse died two years before, when the client was 75, after the client's RBD. The client had named the spouse as beneficiary of the traditional IRA. The client and the spouse were recalculating their life expectancies for minimum required distribution purposes. The client's income is expected to be about $60,000 for 1998. After the spouse's death, the client cannot name a new younger beneficiary to restart the required minimum distribution clock. In fact, because the client and his or her spouse were recalculating life expectancies, the client's IRA must be distributed by the end of the calendar year following the year of the client's death.

  Should this client consider converting his traditional IRA to a Roth IRA? Yes. If the client did nothing and died in 2002 owning the same assets, assuming no growth, the client would have a taxable estate of $500,000 ($1.2 million less the $700,000 exemption available in 2002). The client's estate would be subject to an estate tax of approximately $155,800. Also, under Code 401(a)(9), the client's traditional IRA would have to be distributed about one year after the client's death and would be subject to an additional $200,000 in income taxes, taking the Code  691(c) credit for estate tax on the IRA into account. The total tax cost to the client's estate would be $355,800. What if the client had converted his or her traditional IRA to a Roth IRA in 1998? The client would have to pay approximately $300,000 in income taxes over four years, subject to adjustment for state income taxes.

  If the client died in 2002, he or she would have a taxable estate of $200,000 ($900,000 less $700,000 exemption equivalent) subject to an estate tax of approximately $54,800. Thus, the client's total taxes over the period would be $354,800, or about the same as if he or she had kept the traditional IRA. If the client had converted, however, further distributions from the client's new Roth IRA would not be subject to income tax after the client's death. In addition, once the client converted the traditional IRA, he or she could stop taking minimum distributions during his or her lifetime. Finally, the client could also name new beneficiaries of the Roth IRA after the conversion, perhaps setting aside the account for his or her grandchildren's use in trust for education.

  This could be an extraordinarily valuable opportunity for a client. Return to the example of a $150,000 Roth IRA left to a seven year old, with the same earnings assumptions described above. In that case, the beneficiary could take out $45,000 a year for his or her eight college and graduate school years and take $200,000 out when he or she turned 34 for a housing deposit, in each case from both the Roth IRA and the "after-tax" investment account. When the beneficiary reached age 75, the grandchild's Roth IRA and after-tax account would total more than $1 million.

  All in all, a client's loved ones could benefit from careful and professional consideration of the idea of converting a traditional IRA to a Roth IRA and paying some income taxes up front over four years or, after 1998, one year, rather than waiting until later. Moreover, a client's beneficiaries would have a powerful nontaxable savings account from which to draw for college expenses, home buying and other expected expenses.

  Which clients should consider converting? Any client with a large taxable estate and a large traditional IRA should seriously review the option. Paying the income taxes early will remove the assets used to pay the tax from the client's estate and the conversion will create planning flexibility. Clients who earlier may have considered drawing out a traditional IRA to avoid the IRD rules, and then using the money to purchase life insurance, should also review the Roth IRA option. A client who has passed his or her RBD but failed to name a designated beneficiary for a traditional IRA should also consider converting it to a Roth IRA. Finally, if a client's designated beneficiary dies after the client passes his or her RBD, converting a traditional IRA to a Roth IRA will allow the client to choose new beneficiaries who will be able to use their own life expectancies for the required distributions after the client's death.

  Dealing with the Income Limit
  

  Lawyers considering whether their clients should convert traditional IRAs to Roth IRAs will need to review with their clients how to keep their income below the $100,000 limit for the year of the conversion. Of course, this may not be possible. Nevertheless, the client may have the ability to defer income into later years if, for example, he or she owns shares of a dividend paying close corporation or if he or she has discretion about whether to take income out of a trust set up by his or her spouse. A surviving spouse might also consider converting any stepped-up assets to municipal bonds for a year and then restructuring the investments after year-end to have a more balanced portfolio. By doing this, the client might bring adjusted gross income below $100,000 for the year in question.

  Conclusion
  Estate planning lawyers should view the Roth IRA as a new weapon in the arsenal for reducing taxes and increasing planning flexibility. Although this is a complicated area of law with many intricate rules, in many situations a conversion of a traditional IRA to a Roth IRA can make considerable sense.

  Stephen P. Magowan is an associate with Gravel and Shea in Burlington, Vermont and is a member of the Probate Division's Estate Planning and Estate Administration for Business Owners (C-3) and Employee Benefit Tax Problems (F-5) committees.