Advisors recommending Roth IRA conversions had better be prepared to answer these questions from clients: “For years, you've told me that I should postpone income taxes on my retirement plan as long as possible. Now, you tell me I should do a Roth IRA conversion and pay all of the income tax immediately. Why do this Roth conversion? What's the payoff?”

Come 2010, there's no income limitation to stop people from converting a traditional IRA or other qualified retirement account into a Roth IRA. The question then becomes, how should they do it? (See “Want To Convert to a Roth IRA?” p. 26.)

But perhaps most importantly, we have to answer: Does the Roth make financial sense?

To help calculate the bottom line, here are a few case studies that compare a Roth IRA's financial results to other strategies.

If there is anything surprising about the results of my studies, it's that a Roth IRA conversion strategy dramatically outperforms every other strategy under a wide range of conditions. One of my case studies shows that for an individual with a “modest” net worth of around $3 million, a strategy that has a Roth IRA conversion with a stretch-out and a Roth bearing minimum estate taxes can produce nearly four times the results compared to a non-deferral strategy and roughly double the value produced by the best IRA deferral strategy.

For a wealthy person with a net worth of $65 million, the same Roth IRA conversion strategy more than doubles the results of the best IRA deferral strategy.

And when multi-generations are involved, it's dramatically better to leave the entire Roth IRA to grandchildren — even if generation skipping transfer (GST) tax is incurred.

Let me show you how I reached these conclusions.

Moving Parts

First, let's understand the Roth IRA by acknowledging that it has five moving parts:

  • Pre-Income Tax vs. After-Income Tax Dollars — The first moving part is pretty basic. We already know that, generally speaking, retirement plans and IRAs are established with “pre-income tax dollars” and that “tax-deferred compounding” results during the time interval between contributions and distributions.1

    But we also know that a Roth IRA is established with “after-income tax dollars” and no income tax is generally due when distributions are taken.

    So, query: Is it better to salt away “pre-income tax dollars” or “after-income tax dollars?” To find the answer, consider this example:

    Jan. 1, 2010, Glenda Toprate comes to you for advice. She is 70-years-old and has a high net worth, so all top income and transfer tax brackets apply to her. Her marginal income tax rates (federal and state combined, after allowing for deduction of state income tax) are 45 percent for ordinary income and 25 percent for capital gains. These rates are assumed to remain in effect indefinitely. Glenda's investments earn 6 percent net annual return, consisting of 2 percent ordinary income and 4 percent growth, with 20 percent annual turnover.

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  • Glenda has $1,000 to invest in one of three choices: (1) a normal “outside” investment account (i.e. an account that is not “inside” a retirement plan, IRA, or Roth IRA); (2) an IRA; or (3) a Roth IRA.

    She asks what the value of her $1,000 investment will be under each approach over a 20-year period. Value is calculated as the “liquidation value” at any given point in time, after payment of income taxes and, at least for now, ignoring required minimum distributions (RMDs).

    If Glenda chooses an IRA, she'll actually contribute $1,818.18 in pre-income tax dollars, because the income tax savings from the deduction, $818.18, reduces the net investment to $1,000. And $1,000 happens to be exactly 55 percent of $1,818.18, which makes sense given the assumed income tax rate of 45 percent.

    If Glenda chooses a Roth IRA, this example assumes that it's her first Roth IRA and that the five-year waiting period must pass before qualifying distributions may be taken free of income tax.2

    Examining the after-tax liquidation value of each type of account, (see “Compare After-tax Liquidation Values”) we find:

    1. That the IRA outperforms the outside investment account for any time period, even just one year, even though most of the growth in the outside account is taxed at lower capital gains rates. This is because the IRA is larger — it has $1,818.18 working which produces $109 of overall return in the first year, compared to $60 in the outside account; and
    2. The performance between the IRA and the Roth IRA is identical (except during the five-year waiting period). In other words, $1 in an IRA is worth exactly the same as 55 cents in a Roth IRA in the simplified facts of this example. Thus, the fact that the Roth IRA works with “after-income tax dollars” does not necessarily mean that the Roth IRA has any inherent advantage over the IRA.
  • The Concentration Effect — The next moving part has to do with the fact that contributions to IRAs (and other types of qualified retirement plans) are generally subject to the same fixed dollar limits. Let's go back to our hypothetical.

    Let's say Glenda Toprate requests another comparison, except that this time she has $6,000 to invest. The limit for 2010 deductible IRA contributions and for 2010 Roth IRA contributions is assumed to be $6,000 (ignoring the inflation indexing scheduled for 2010), consisting of a $5,000 annual contribution3 plus a $1,000 catch-up contribution for an individual who is 50 years of age or older.4 If Glenda contributes to an IRA, she'll invest $6,000 in an IRA (the maximum allowed), producing an income tax deduction that saves her $2,700, which will be invested in outside investments. This hypothetical ignores RMDs for now but does compare:

    1. $6,000 in outside investments;
    2. $6,000 in a traditional IRA plus $2,700 of outside investments; and
    3. $6,000 in a Roth IRA.

    Here, the Roth IRA outperforms the other options. Glenda would need to somehow invest $10,909 in an IRA for the IRA to keep up with the Roth IRA ($6,000 divided by 55 percent), and this is not possible because the $6,000 contribution limit applies to both IRAs and Roth IRAs. She has no choice but to invest the excess funds in an outside account, which brings down the overall performance of the traditional IRA option.

    Thus, the Roth IRA has an inherent advantage over a traditional IRA, because the dollar limits are generally the same. This allows a greater “concentration” of tax-advantaged investments with a Roth IRA. In this example, the liquidation value of the Roth IRA is roughly 15 percent higher than the liquidation value of the IRA alternative after 20 years.


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  • Note that the same principle applies in a Roth IRA conversion if the income taxes on the conversion are paid from outside assets, because the Roth IRA will be the same size as the IRA that is converted. (See “The Roth IRA Pulls Ahead” )

  • Minimum Distributions — Unlike traditional IRAs,5 the RMD rules do not apply to a Roth IRA until the participant's death.6

    Let's add the RMD rules to our example, beginning with the fact pattern from Glenda's first example ($1,000 available to invest). Compare:

    1. an investment of $1,818.18 in an IRA and
    2. an investment of $1,000 in a Roth IRA.

    The values in the traditional IRA now reflect the RMDs Glenda takes during her lifetime and reinvests, net of income tax, in outside investments.

    The Roth IRA, which is allowed to accumulate without RMDs, reaches a liquidation value that is roughly 11 percent larger than the combined liquidation value of the IRA and the “outside” account over the 20-year period. (See “Factor in RMDs”)

  • Estate Tax — Now, let's look at the impact of death and estate tax on the alternatives in our hypotheticals: outside investments, IRA or Roth IRA.

    We'll start with the same facts as in our first example ($1,000 to invest), but now Glenda asks how much her child will inherit, net of income and estate tax, if she dies at age 87 and her child then liquidates (ignoring RMDs). Glenda is particularly interested in knowing how the outside investments perform in view of the lower capital gains rates and stepped up cost basis that occurs at death.

    This time, we're assuming that any funds needed for estate or income taxes must come from the account in question, which is admittedly harsh. Eighty-two percent of the IRA must be withdrawn to fully satisfy the 45 percent estate tax and the 45 percent income tax on the distributions taken to pay both taxes. I call this an “IRA meltdown.” In most real-life situations an IRA meltdown can be avoided, because there are other funds available to pay estate taxes.

    During Glenda's lifetime the IRA and the Roth IRA perform identically, and they substantially outperform the outside investment account by roughly 31 percent. At death, the IRA melts down and the outside investment account nudges a little closer to the Roth IRA, but the Roth IRA is still 22 percent ahead.

    Even if the traditional IRA does not melt down, it's not the best choice. That's because more outside funds are needed to pay the estate tax on the IRA in our example, as the IRA will be 55 percent larger than the Roth IRA.

    One of the key advantages of converting an existing IRA to a Roth IRA is that the income taxes paid on the conversion are paid with pre-estate tax dollars. This produces a significantly lower combined tax than if estate tax is paid first on the IRA, and income taxes are paid after death with after-estate tax dollars, even after considering the income tax deduction that is allowed under IRC Section 691 for estate taxes paid on income in respect of a decedent (IRD). (See “Leaving IRAs to Your Estate's Heirs?”)

    I suggest that any death-bed planning checklist include the Roth IRA conversion as an eleventh-hour method for reducing estate taxes.

  • Stretched-out Distributions to Beneficiary(ies) — The last, and likely the most powerful moving part is the power of extending the tax-advantaged status of the account for as long as possible by limiting distributions to the minimum required under the RMD rules.

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What is the result if Glenda's child takes stretched-out RMDs rather than liquidating the account at her mother's death? To answer this, we need to get into a more detailed and sophisticated approach to the financial analysis.

I've developed a detailed financial model for this purpose. Each hypothetical prepared using this model makes detailed calculations of everything going on for the IRA owner and for their beneficiary over the extended time period during which stretched-out RMDs could occur. The net assets remaining at the end of the time period are expressed net of all taxes and costs, and provide a true apples-to-apples comparison of the performance of different distribution strategies. For more information on how this model works, see “Steve Trytten supporting documents for ‘Show Me the Money,’” at www.trustsandestates.com.

Case Studies

Two case studies compare the basic strategies available in stretch-out planning.

The first is for a client with modest net worth whom we'll call Robert Jones and his son. By “modest,” I assumed in this case a net worth of about $3 million.

The second is for a high-net-worth client whom we'll call Wilma Clemons and her daughter Betty; by “high-net-worth,” I'm assuming a net worth of about $65 million.

Modest Net Worth — Robert Jones visits his planner in the year 2008. Rob is 75-years-old (born Jan. 1, 1933), and is widowed with one child, a son named Charlie, age 34 (born Jan. 1, 1974). Rob wants to leave his entire estate to Charlie. But he's worried there won't be much left for Charlie after estate and income taxes, and wants to know how his son would fare under various distribution strategies. Rob's estate consists of an IRA worth $1 million, liquid investments worth $1.5 million and a residence worth $500,000. Let's assume:

  • All investments earn 8 percent annual return, consisting of 1.5 percent ordinary income and 6.5 percent growth. Portfolio turnover is 20 percent per year.

  • Investments incur a 1 percent asset management fee, thus the net rate of return is 7 percent.

  • Rob receives a $72,000 pension each year, $15,000 of Social Security (indexed for inflation), and has living expenses of $48,000 per year (indexed for inflation).

  • Annual inflation will be 1.5 percent throughout the projection period.

  • Rob has not made any prior taxable gifts.

  • The projections assume that Rob will die at age 84 (Dec. 31, 2017).

  • Given the child's age (43-years-old the year that Rob dies), the potential period of deferral for the child will continue through the year 2057. Thus, this case study evaluates a 50-year deferral period, from 2008 to 2057, with potential deferral based on Uniform Lifetime Table factors derived from the IRA owner's life expectancy during the first 10 years, and based on single life table factors derived from the child's life expectancy for the 40 years remaining.

  • Rob's child earns $50,000 per year (indexed) and has living expenses of $32,000 per year (indexed). When Charlie reaches age 65 he will receive Social Security benefits of $8,000 per year (in 2008 dollars, indexed for inflation).

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  • Income and estate tax laws are assumed to reflect what would happen if the provisions of the Economic Growth Tax Relief Reconciliation Act sunset as scheduled, and no other changes to the tax law are enacted. The financial model includes provisions for alternative minimum tax (AMT), taxation of a portion of Social Security, IRD deduction, 3 percent phase-out (haircut) of itemized deductions, limitations on charitable deductions, compressed rate brackets for trusts, etc. The IRD deduction will be utilized on the earliest dollars distributed, as discussed earlier.

  • IRA distributions to trusts are taxed at the trust's level (and IRD deductions deducted at the trust's level) until the IRD deduction is fully utilized. Note that it may be necessary for the trust to accumulate (that is to say, not make any distributions) to accomplish this.

Let's identify the various planning strategies available:

  1. Distribute Entire Plan in 2008For Comparison Purposes Only — If Rob believed that the income tax benefits associated with outside investment accounts (such as lower capital gains rates and basis step up at death) would provide a better outcome than an IRA, he might take distribution of the entire IRA at the start. We already know from the prior examples that this is probably not the best option for Rob, but it does serve as a useful benchmark to compare the results produced by the other deferral strategies. Thus, as strategy #1, Rob takes full distribution of his IRA balance during the current year of 2008.

  2. Distribute on Death Bed — Rob takes minimum distributions until the year of his death, and takes full distribution of his IRA immediately prior to his death.

  3. Distribute Just After Death — Rob takes minimum distributions during his life. Immediately after his death, his child takes full distribution of the IRA.

  4. Stretch-out; IRA Bears Pro Rata Death Tax — Rob takes minimum distributions during his life. After Rob's death, his son Charlie continues minimum distributions during Charlie's life. But an IRA withdrawal is made shortly after Rob's death to pay the IRA's pro rata share of death taxes. Charlie pays the income tax on the IRA withdrawal from non-IRA assets first, and if insufficient, from the IRA.

  5. Stretch-out; IRA Bears Minimum Death Tax — Rob takes minimum distributions during his life. After Rob's death, Charlie continues minimum distributions during his life. Unlike strategy #4, death taxes are paid from non-IRA assets first, and only are apportioned to the IRA to the extent that other assets are insufficient to pay them.

  6. Stretch-out to “Accumulation” Trust; IRA Bears Minimum Death Tax — Same as strategy #5, except that the IRA is designated to an “accumulation” trust that qualifies for stretch-out using the child's life expectancy, but accumulates IRA distributions and pays income tax inside the trust. This is not a “conduit” trust, and drafting this type of trust may require careful attention to special drafting issues. (See “Got Stretch-out?” Trusts & Estates, July 2009, at p. 41).

  7. Roth IRA Conversion Stretch-out; IRA Bears Minimum Death Tax — Same as strategy #5, except that Rob converts the entire IRA to a Roth IRA in 2008, and pays all income taxes arising from the conversion from non-retirement assets. (For illustration purposes, the financial model assumes that Rob qualifies to make the Roth IRA conversion in 2008, even though in reality he would not qualify, as his “adjusted” AGI for 2008 exceeds $100,000.)

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So how do the strategies compare? (See “How the Moderately Wealthy Can Profit”) I find it more useful to look at the end results in percentage terms. I set the first strategy of “non-deferral” arbitrarily at 100 percent and let it form the basis of comparison to the other strategies.

  • The “Distribute on Death Bed” strategy outperforms the “Distribute Just After Death” strategy by roughly 15 percent. This shows that it's more efficient to pay income tax first with pre-estate tax dollars, than to pay income tax second with after-estate tax dollars, even after considering the IRD deduction for estate tax.

  • The “Stretch-out; IRA Bears Pro Rata Death Tax” strategy shows a substantial benefit of 49 percent, but the “Stretch-out; IRA Bears Minimum Death Tax” strategy shows a much greater benefit of 84 percent (in other words, the net assets remaining at the end of the period are 84 percent higher — nearly double!). This tells us that stretch-out is valuable, and it also tells us that it is costly to take IRA distributions to pay death taxes. If possible, death taxes should be paid from non-IRA assets. This may require special planning or drafting in some cases.

  • The “Stretch-out to Accumulation Trust; IRA Bears Minimum Death Tax” strategy provides an 81 percent benefit, showing that the cost of taking IRA distributions at the compressed income tax rates that apply to trusts has a minor impact in this case. In fact, if the individual beneficiary is in the highest income tax bracket, paying income tax at the trust level will not necessarily increase income tax, and might even reduce it, depending on the interplay of the AMT and the various limitations on deductions.

  • The “Roth IRA Conversion Stretch-out; Roth IRA Bears Minimum Death Tax” strategy shows the astounding power of the Roth IRA conversion: a 272 percent increase. This results in net assets remaining at the end of the period of nearly four times the value produced by the non-deferral strategy, and roughly double the value produced by the best IRA deferral strategy. All the IRA's working parts are involved in producing this amazing result.

High-Net-Worth Case Study

Now let's look at how this all breaks down for the high-net-worth individual.

Let's say that Wilma Clemons is a very successful business woman, with one daughter, Betty. Wilma visits her planner in the year 2008. Her facts are the same as Rob's (for example, she and her daughter are the same respective ages as Rob and his son). The difference here is that Wilma's assets are $5 million in an IRA, $50 million in liquid investments, and a residence worth $10 million. Wilma earns $1 million annually and her daughter Betty earns $500,000 annually.

In broad terms, the relative performance of the various strategies is similar in both Rob's and Wilma's cases. Higher income taxes mute the performance of the stretch-out strategies a little. A higher death tax magnifies the problems that arise with the “Distribution Just After Death” and “Stretch-out; IRA Bears Pro Rata Death Tax” strategies.

The Roth IRA conversion is still an outstanding choice for this high-net-worth family, showing a 257 percent increase, and more than doubling the results of the best IRA deferral strategy. (See “How the Truly Wealthy Can Profit”)

If anything can be guaranteed about these financial illustrations, it's that they'll be wrong. Reality always turns out different than our expectations. Financial modeling is not so much about predicting the future as it is about learning about how moving parts work.

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The best way to really understand moving parts is to move them. The financial model used in Rob's and Wilma's case studies required input of a large number of variables. The results can be very sensitive to many of these variables, and it's important for us to understand how each variable can affect the results.

To accomplish this, the following variations on Rob's and Wilma's case studies were run to isolate the following variables through a wide range of values while keeping all other variables the same:

  1. investment return (level return);
  2. investment return (fluctuating returns);
  3. portfolio turnover;
  4. payment of investment fees from inside or outside IRA/Roth IRA;
  5. estate tax rates and exemption;
  6. income tax rates and changes to AMT or IRD deduction;
  7. participant's mortality; and
  8. beneficiary's age.

These alternative case studies are voluminous, and can be found in the Trusts & Estates online library at www.trustsandestates.com under “Supporting documents for Steven Trytten's ‘Show Me the Money’.”

These case studies confirm that changes in these variables produce wide variations in results in absolute dollar terms. Changes in these variables can also widen or narrow the gap between the results of any two strategies.

But what is remarkable about this extensive group of case studies is that the same strategies come out on top in almost every case. In other words, the relative performance of the various strategies is quite consistent across a wide range of scenarios.

In particular, the Roth IRA conversion strategy dramatically outperforms all other strategies in every case. The Roth IRA conversion strategy consistently produced performance of 300 percent to 400 percent relative to the non-deferral strategy in most cases. The variables that reduced relative performance the most were: (a) reduction or elimination of estate tax; and (b) an older beneficiary. In these scenarios, the Roth IRA conversion strategy still managed performance of roughly 250 percent to 300 percent relative to the non-deferral strategy.

The lowest performances of all were:

  1. total estate tax repeal in 2010 (Roth IRA conversion performance was “only” 251 percent for Rob and 244 percent for Wilma); and
  2. beneficiary who is age 63 at Roth IRA owner's death (Roth IRA conversion performance was “only” 242 percent for Rob and 232 percent for Wilma).

In no scenario did another strategy come close to the performance of the Roth IRA conversion.

But wait, it gets better. Let's take a quick look at a multi-generational case study.

Multi-Generational

My multi-generational case study has not been updated since it was prepared in 2003. But I believe that the results are still useful under current law.

Let's say Grandpa Joe's situation is similar to Rob's, except that Joe has one child (named Daphne, age 30) and one grandchild (Sam, age 4). Joe wants to see the impact of various planning approaches that use his GST exemption. His estate consists of an IRA worth $500,000, liquid investments of $1 million and a residence worth $500,000.

The assumptions are generally the same as with Rob, with the following additional or changed facts:

  • Grandpa Joe has not made any prior taxable gifts or GST exemption allocations. He is assumed to die at age 82, and his child is also assumed to die at age 82.

  • The GST exemption amount in the year of Joe's death is assumed to be $1.36 million, roughly what inflation indexing would provide under pre-2001 law.

  • Joe's daughter Daphne earns $40,000 per year (indexed) and has cash outflow of $30,000 per year (indexed). When Daphne reaches age 65, she'll receive social security benefits of $8,000 per year (in 2003 dollars, indexed for inflation).

  • Beginning at age 21, Joe's grandchild Sam will earn $40,000 per year (indexed) and will have cash outflow of $30,000 per year (indexed). When Sam reaches age 65, he'll receive social security benefits of $8,000 per year (in 2003 dollars, indexed for inflation).

  • Current income tax rules will remain in effect (indexed for inflation), for example, AMT, taxation of a portion of social security, IRD deduction, 3 percent phase-out (haircut) of itemized deductions, limitations on charitable deductions, compressed rate brackets for trusts, etc. The IRD deduction will be used on the earliest dollars distributed.

So let's look at the strategies available:

  • Distribute in 2003 — Grandpa Joe takes full distribution during the year 2003.

  • Distribute on Death Bed — Joe takes minimum distributions until death and takes full distribution just prior to death.

  • Stretch-out to the Child — Joe designates his child who takes minimum distributions. Death taxes are apportioned to other assets.

  • Stretch-out; $1.36 Million Investments to the Grandchild — Same as scenario #3, except Joe directs investment assets to grandchild in amount of then-indexed GST exemption ($1.36 million).

  • Stretch-out; $1.36 Million IRA to the Grandchild — Same as scenario #3, except Joe designates portion of IRA to grandchild equal to the then-indexed GST exemption; other assets pass to his child. Both Daphne and Sam take RMDs.

  • Stretch-out; Entire IRA to the Grandchild (Incurs GST Tax) — Joe designates the entire IRA to his grandchild, and pays GST tax at death; other assets pass to his child. Sam takes RMDs.

  • Stretch-out; $1.36M Roth IRA to the Grandchild — Same as scenario #5 except that Joe completes a conversion of his entire retirement plan to a Roth IRA in the year 2003 (paying income tax from non-IRA assets).

  • Stretch-out; Entire Roth IRA to the Grandchild (Incurs GST tax) — Same as scenario #6 except that Joe completes a conversion of his entire retirement plan to a Roth IRA in the year 2003 (paying income tax from non-IRA assets).

Let's examine the results (See “Multi-generational Planning”):

  • Strategy #4 shows a huge leap in performance (489 percent) over prior strategies, not because of any particular deferral strategy, but because it's the first strategy to incorporate multi-generational planning.

  • Strategy #5 shows an additional increase in performance (721 percent) that arises from using IRA assets to fund the GST exempt gift to grandchildren.

  • Strategy #6 suggests, at least in the facts of this case study, that it's better to leave the entire IRA to grandchildren even if GST tax is incurred. (This case study assumes that the GST tax is paid from other assets that would otherwise pass to the children.)

  • Strategy #7 shows the phenomenal results possible when a Roth IRA conversion is established with grandchildren as beneficiaries — performance is 1,307 percent!

  • Strategy #8 suggests, at least in the facts of this case study, that it can be dramatically better to leave the entire Roth IRA to grandchildren even if GST tax is incurred. (This case study assumes that the GST tax is paid from other assets that would otherwise pass to the children.)

Check It Out

Clearly, there's a payoff to the Roth IRA conversion. The Roth IRA conversion produces such dramatic results because of the way the various moving parts act together. But this payoff is only one of several planning trade-offs that should be evaluated for each client before a decision is made to proceed with a Roth IRA conversion or any other deferral strategy.

Endnotes

  • My references in this article to IRAs generally refer to all IRA and retirement plans funded with pre-income tax dollars.
  • Internal Revenue Code Section 408A(d)(2)(B) as amended by 98 Act Section 6005(b)(3)(A), effective for tax years beginning after Dec. 31, 1997.
  • IRC Section 219(b)(5)(A).
  • IRC Section 219(b)(5)(B).
  • IRC Section 408(a)(6).
  • IRC Section 408A(c)(5).

Steven E. Trytten is a partner in the Pasadena, Calif., office of Anglin, Flewelling, Rasmussen, Campbell & Trytten LLP

The assumptions are generally the same as with Rob, with the following additional or changed facts:

  • Grandpa Joe has not made any prior taxable gifts or GST exemption allocations. He is assumed to die at age 82, and his child is also assumed to die at age 82.

  • The GST exemption amount in the year of Joe's death is assumed to be $1.36 million, roughly what inflation indexing would provide under pre-2001 law.

  • Joe's daughter Daphne earns $40,000 per year (indexed) and has cash outflow of $30,000 per year (indexed). When Daphne reaches age 65, she'll receive social security benefits of $8,000 per year (in 2003 dollars, indexed for inflation).

  • Beginning at age 21, Joe's grandchild Sam will earn $40,000 per year (indexed) and will have cash outflow of $30,000 per year (indexed). When Sam reaches age 65, he'll receive social security benefits of $8,000 per year (in 2003 dollars, indexed for inflation).

  • Current income tax rules will remain in effect (indexed for inflation), for example, AMT, taxation of a portion of social security, IRD deduction, 3 percent phase-out (haircut) of itemized deductions, limitations on charitable deductions, compressed rate brackets for trusts, etc. The IRD deduction will be used on the earliest dollars distributed.

So let's look at the strategies available:

  • Distribute in 2003 — Grandpa Joe takes full distribution during the year 2003.

  • Distribute on Death Bed — Joe takes minimum distributions until death and takes full distribution just prior to death.

  • Stretch-out to the Child — Joe designates his child who takes minimum distributions. Death taxes are apportioned to other assets.

  • Stretch-out; $1.36 Million Investments to the Grandchild — Same as scenario #3, except Joe directs investment assets to grandchild in amount of then-indexed GST exemption ($1.36 million).

  • Stretch-out; $1.36 Million IRA to the Grandchild — Same as scenario #3, except Joe designates portion of IRA to grandchild equal to the then-indexed GST exemption; other assets pass to his child. Both Daphne and Sam take RMDs.

  • Stretch-out; Entire IRA to the Grandchild (Incurs GST Tax) — Joe designates the entire IRA to his grandchild, and pays GST tax at death; other assets pass to his child. Sam takes RMDs.

  • Stretch-out; $1.36M Roth IRA to the Grandchild — Same as scenario #5 except that Joe completes a conversion of his entire retirement plan to a Roth IRA in the year 2003 (paying income tax from non-IRA assets).

  • Stretch-out; Entire Roth IRA to the Grandchild (Incurs GST tax) — Same as scenario #6 except that Joe completes a conversion of his entire retirement plan to a Roth IRA in the year 2003 (paying income tax from non-IRA assets).

Let's examine the results (See “Multi-generational Planning,” p. 44):

  • Strategy #4 shows a huge leap in performance (489 percent) over prior strategies, not because of any particular deferral strategy, but because it's the first strategy to incorporate multi-generational planning.

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  • Strategy #5 shows an additional increase in performance (721 percent) that arises from using IRA assets to fund the GST exempt gift to grandchildren.

  • Strategy #6 suggests, at least in the facts of this case study, that it's better to leave the entire IRA to grandchildren even if GST tax is incurred. (This case study assumes that the GST tax is paid from other assets that would otherwise pass to the children.)

  • Strategy #7 shows the phenomenal results possible when a Roth IRA conversion is established with grandchildren as beneficiaries — performance is 1,307 percent!

  • Strategy #8 suggests, at least in the facts of this case study, that it can be dramatically better to leave the entire Roth IRA to grandchildren even if GST tax is incurred. (This case study assumes that the GST tax is paid from other assets that would otherwise pass to the children.)

Check It Out

Clearly, there's a payoff to the Roth IRA conversion. The Roth IRA conversion produces such dramatic results because of the way the various moving parts act together. But this payoff is only one of several planning trade-offs that should be evaluated for each client before a decision is made to proceed with a Roth IRA conversion or any other deferral strategy.

Endnotes

  • My references in this article to IRAs generally refer to all IRA and retirement plans funded with pre-income tax dollars.
  • Internal Revenue Code Section 408A(d)(2)(B) as amended by 98 Act Section 6005(b)(3)(A), effective for tax years beginning after Dec. 31, 1997.
  • IRC Section 219(b)(5)(A).
  • IRC Section 219(b)(5)(B).
  • IRC Section 408(a)(6).
  • IRC Section 408A(c)(5).

Steven E. Trytten is a partner in the Pasadena, Calif., office of Anglin, Flewelling, Rasmussen, Campbell & Trytten LLP