For many families, tax-deferred retirement accounts provide a major source of wealth to be passed to later generations.1 Today, such accounts make up nearly one-third of total U.S. household financial wealth.2 And for good reason! Tax deferral may provide an investment benefit of nearly 70 basis points per year.3 Given this advantage, taxpayers have traditionally sought to extend the tax-deferral period for as long as possible.
However, with the benefits of tax deferral come significant planning complications for taxpayers subject to a potential estate tax liability. A taxpayer’s taxable estate includes the value of any retirement accounts held at death, even though an inheriting beneficiary may still owe income tax on the account funds. Additionally, a taxpayer seeking to transfer retirement account funds outside of their taxable estate must first pay income tax on any pre-tax contributions and built-in gain within the account. Thus, taxpayers must choose between paying income taxes today or estate taxes in the future.
Impending estate tax law changes have exacerbated this estate-planning dilemma. Currently, the gift and estate tax exclusion stands at an inflation-adjusted $12.06 million per individual (or $24.12 million per married couple), with less than one-tenth of 1% of decedents each year likely to be subject to federal estate tax.4 In 2026, however, the Tax Cuts and Jobs Act (TCJA) sunset provisions will halve the exclusion to approximately $6 million per individual (indexed for inflation), thereby tripling the number of expected estate tax return filings for each year thereafter.5
Faced with the possibility of an increased estate tax burden, many wealthy taxpayers are considering executing wealth transfer tax strategies, including gifts, irrevocable grantor trusts and grantor retained annuity trusts (GRATs).6 However, all these wealth transfer strategies have traditionally focused on non-retirement account assets. For tax-deferred retirement accounts, Roth conversions have typically served as the go-to approach when it comes to wealth transfer planning. Traditionally, little consideration has been given to retirement accounts as funding sources for gifts during life due to negative income tax consequences. Let’s reexamine these conclusions in light of the TCJA sunset provisions.
Income Tax Savings
By converting from a traditional individual retirement account to a Roth account, a taxpayer will recognize the account’s pre-tax contributions and built-in gain as ordinary income in exchange for a waiver of the taxpayer’s required minimum distributions (RMDs) and access to future tax-free withdrawals, subject to certain exceptions.7 Despite their upfront costs, such benefits can significantly increase the account’s after-tax value.
For example, a 72-year-old taxpayer8 who begins taking RMDs from a traditional IRA in 2022 must receive an initial distribution of 3.6% of the account’s value.9 However, this relatively modest distribution rate grows to nearly 9.3% by age 92. If instead, the taxpayer converts the account to a Roth IRA at age 72, the additional tax deferral achieved by eliminating all RMDs and the absence of a tax liability on later withdrawal can produce as much as a 14% increase in after-tax wealth by age 92 and a 24% increase by age 102.10 This is without considering any benefits from estate tax savings or the beneficiary’s ability to continue further tax deferral.
It should be noted, however, the above example hinges on the beneficiary’s income tax rate. Our example assumes that the beneficiary’s income tax rate equals the taxpayer’s tax rate at the time of conversion. If the beneficiary’s income tax rate is instead lower than the taxpayer’s tax rate, the Roth conversion could result in less after-tax wealth for the beneficiary, depending on the beneficiary’s time horizon for withdrawal.11
Estate Tax Savings
In addition to the above income tax benefits, a Roth conversion may provide estate tax savings, as accelerating payment of income taxes on the account funds necessarily decreases the taxpayer’s taxable estate. For example, let’s consider a taxpayer with a $10 million traditional IRA and a $10 million taxable account and assume that the entire estate will be subject to estate tax. By converting the traditional IRA to a Roth IRA, the taxpayer will trigger payment of a $3.7 million income tax liability (assuming top marginal federal income tax rates). Were this $3.7 million to stay in the taxpayer’s taxable estate, it would generate an estate tax liability of just under $1.5 million. But by reducing the size of the taxable estate in exchange for discharging any future income tax liability on the IRA, the taxpayer provides the estate’s beneficiaries with $9.78 million on an after-tax basis.
At first blush, the federal income in respect of a decedent (IRD) deduction seems to eliminate the above benefit. Beneficiaries may apply this deduction to reduce taxable income from inherited tax-deferred assets by the amount of estate taxes paid on such assets.12 If we return to the above example but assume that the taxpayer doesn’t proceed with a Roth conversion, the estate will pay an estate tax liability of $8 million and produce an IRD deduction of $4 million. The beneficiary then would pay income tax on the amount of the IRA minus the IRD deduction amount (that is,
$6 million), for a total income tax liability of $2.22 million. Again, this leaves the beneficiaries with $9.78 million on an after-tax basis.
However, this result depends on the beneficiary immediately liquidating the traditional IRA on receipt. A beneficiary generally only recognizes the benefit from an IRD deduction on withdrawing funds from the IRA, and the value of such benefit may decrease if realized over time for two reasons. First, the amount of the IRD deduction is fixed, meaning that its provided value diminishes over time due to inflation and cost opportunities. Second, the TCJA sunset provisions provide for an IRD deduction phaseout for taxpayers with high incomes after 2025.13
After we account for estate taxes and the IRD deduction phaseout, a Roth conversion produces significantly more wealth over time for the beneficiaries. “No Conversion vs. Roth Conversion,” p. 68, compares a $12 million Roth conversion to a base case in which the participant maintains a $12 million traditional IRA and $4.4 million taxable portfolio.14 All accounts have a moderate growth allocation of 60% global equities and 40% investment-grade fixed income.15
The values in “No Conversion vs. Roth Conversion” represent the beneficiary’s net after-tax wealth for purposes of both income and estate taxes, assuming the beneficiary extends the inherited IRA’s tax deferral period to the maximum extent possible. The ramifications are:
- no distributions from the inherited IRA accounts until the end of the 10th year following the participant’s death if the participant dies at ages 65 or 70 (before the participant’s required start date for RMDs)
- per proposed Treasury regulations, we assume annual distributions based on the taxpayer’s fixed life expectancy from the year of death for 10 years following the taxpayer’s death after age 72.16
- the participant’s applicable exclusion reduces to $6.03 million adjusted for inflation after 2025.17
Under these assumptions, we see the Roth conversion enhances beneficiary wealth by more than 30% over time. This remains the case even when the participant dies after age 72, requiring the beneficiary to take annual distributions from the inherited Roth IRA during the 10 years following the participant’s death.
Importantly, the above analysis relies on a taxpayer being able to pay the $4.4 million income tax liability from non-retirement assets. The Roth conversion becomes much less appealing if the taxpayer must spend down the IRA to pay such tax liability, as this leaves less funds to recoup the cost through tax-free growth.18
What if the taxpayer opted to make a gift of the $4.4 million of non-retirement assets to their beneficiary instead of engaging in a Roth conversion? The gift of $4.4 million simply uses $4.4 million of the taxpayer’s exclusion, leaving the beneficiary in the same place as our base case when the taxpayer dies within five years of making the gift. However, suppose the taxpayer survives the gift by 10 or 20 years. In these cases, the taxpayer leverages the used $4.4 million exclusion to remove not only the gift amount but also material appreciation on such property out of the taxpayer’s taxable estate. As shown in “Gift vs. Roth Conversion,” this page, the gift scenario provides a 2% benefit over the base case when the taxpayer survives the gift by at least 10 years. If the taxpayer survives the gift by 20 years, the benefit jumps to just under 10%. While this gift scenario bests the base case over a longer period, it still falls far short of the benefit provided by a Roth conversion.
Lifetime Gifts From IRAs
Taxpayers haven’t traditionally considered IRAs as funding sources for lifetime gifts because of the resulting loss of tax deferral and recognition of taxable income. The consensus has been that these income tax costs outweigh the future estate tax savings produced by the gift. However, we may need to reexamine this conclusion as we approach the 2026 sunset of the current increased exclusion.
With a 40% estate tax rate, the $6.03 million reduction in available exclusion (the excess exclusion) represents a loss of $2.4 million in estate tax savings. To capture this $2.4 million tax benefit, a taxpayer must use the full $12.06 million exclusion before 2026, as applicable Treasury regulations grant a taxpayer’s estate the benefit of the greater of: (1) the exclusion amount at death; or (2) the exclusion used during life.19 For example, if a taxpayer makes a gift of $9 million now and dies in 2026 or later, the taxpayer’s estate will receive the benefit of the full $9 million exclusion. If instead, the taxpayer makes a gift of $4 million today and dies in 2026 or later, the taxpayer’s estate will receive the benefit of the $4 million exclusion previously used and only an additional $2 million, adjusted with inflation of unused exclusion (that is, the exclusion amount at the time of death). For this reason, in the $4.4 million gift scenario described above, any estate tax savings comes from the growth of the gift outside of the estate over time, rather than preservation of the excess exclusion. This explains why we don’t see any meaningful benefit from this strategy until Year 10.
Now, let’s assume that the taxpayer from the above case liquidates the entire traditional IRA to make a $12.06 million gift and compare this strategy to our base case and Roth conversion scenarios. In our base case scenario, the beneficiary inherits a $12 million traditional IRA and a $4.4 million taxable account. In the Roth conversion scenario, the beneficiary only inherits a $12 million Roth IRA because the taxpayer used the taxable account to pay income taxes on the conversion. Lastly, in the $12 million gift scenario, the beneficiary inherits a $12 million taxable account, because again the taxpayer used the $4.4 million taxable account to pay income taxes on the IRA assets.20
When comparing all three wealth transfer strategies, the $12 million gift scenario generates nearly 50% more wealth than the base case scenario, largely due to the $2.4 million of estate tax savings provided by capturing the excess exclusion.21 Additionally, while the $12 million gift scenario’s benefit over the Roth conversion scenario wanes over time, it never fully dissipates. The beneficiary’s RMDs diminish the Roth’s tax-free compounding by slowly draining the account’s funds. See “Comparing All Three Strategies,” this page.
A Changed Analysis
The impending 2026 sunset of our current $12.06 million exclusion has changed the analysis for taxpayers considering wealth transfer planning with retirement accounts. Based on our above research, taxpayers wealthy enough to afford a $12 million gift may realize a benefit from using tax-deferred retirement accounts to make gifts now, provided the time horizon and other taxpayer-specific nuances align. But all isn’t lost for those taxpayers who can’t afford to give away most of their exclusion before the sunset. Even without locking in the excess exclusion, a Roth conversion may provide robust income and estate tax benefits.
—For illustrative purposes only; not an advertisement and doesn’t constitute an endorsement of any particular wealth transfer strategy. Bernstein doesn’t provide legal or tax advice. Consult with competent professionals in these areas before making any decisions.
Endnotes
1. According to a study published by the Congressional Budget Office, retirement assets accounted for 28% of the financial assets reported for taxable estates over $50 million and over 68% of the financial assets reported for taxable estates under $10 million in 2018. Congressional Budget Office, Understanding Federal Estate and Gift Taxes (June 2021).
2. Investment Company Institute, Quarterly Retirement Market Data (Dec. 16, 2021).
3. Based on AllianceBernstein’s (AB’s) estimates of median returns for applicable capital markets over the next 10 years for a portfolio of 60% global equities and 40% investment-grade fixed income and assuming top marginal federal income tax rates.
4. Urban-Brookings Tax Policy Center, Tax Policy Center Briefing Book (2021).
5. Urban-Brookings Tax Policy Center, Model Estimates, T17-0308 (2017).
6. Please note that several proposals included in the Biden administration’s fiscal year 2023 revenue proposals seek to significantly limit the effectiveness of these strategies.
7. Internal Revenue Code Section 408A(d)(1).
8. Under IRC Section 409(a)(1)(C) as currently in force, required minimum distributions (RMDs) generally begin at age 72. On March 29, 2022, the House of Representatives passed H.R.2954—Securing a Strong Retirement Act of 2021 (414-5), which would increase the required beginning age for RMDs from 72 to 75 over a 10-year period. The bill must still pass the Senate and be signed into law by the President.
9. The Uniform Lifetime Table determines the applicable RMDs during a taxpayer’s lifetime in most cases. The Joint Life and Last Survivor Expectancy Table applies only when a taxpayer’s spouse who’s more than 10 years younger than the taxpayer is the account’s sole beneficiary.
10. This assumes an investment allocation of 60% global equities and 40% investment-grade fixed income. Returns are based on AB’s estimates of the range of returns for the applicable capital markets. Data don’t represent past performance and aren’t a promise of actual future results or a range of future results.
11. A Roth conversion remains attractive over a longer time horizon even when the beneficiary’s tax rate equals or is less than the rate applied to the conversion. Over a 25-year horizon, future tax rates would need to decline by more than 7% before the benefit disappears. See AB, “A Window of Opportunity, an Optimal Environment for Roth Conversions” (2020), www.bernstein.com/content/dam/bernstein/us/en/pdf/whitepaper/WindowofOpportunity.pdf.
12. IRC Section 691(c); Treasury Regulations Section 1.691(c)-1.
13. IRC Section 68(f).
14. In the Roth conversion scenario, we assume the taxpayer has used the $4.4 million taxable account to pay income taxes on the conversion.
15. Returns are based on AB’s estimates of the range of returns for the applicable capital markets. Data don’t represent past performance and aren’t a promise of actual future results or a range of future results.
16. Proposed Regulations Section 1.401(a)(9)-5(d)(1)(i), (ii); Treas. Regs. Section 1.401(a)(9)-5(d).
17. IRC Section 2010(c)(3)(C).
18. See AB, “Roth to Riches: Determining Whether a Roth Conversion Makes Sense” (2009), www.bernstein.com/content/dam/bernstein/us/en/email/pdf/GRI-Sp10_GlobalResearchInsights.pdf.
19. Treas. Regs. Section 20.2010-1(c)(2)(i).
20. If the taxpayer were under age 59 1/2, an additional 10% tax would apply to liquidated IRA’s taxable proceeds. IRC Section 72(t).
21. A much smaller benefit may be attributed to the growth of the $12 million gift outside the taxpayer’s taxable estate.