Gyroscopic Investing

I was recently thinking about the income tax ramifications of moving assets from a traditional 401(k) account to a Roth, realizing that, even if tax rates don't go up, you can effectively get more assets into the tax shelter by paying taxes with outside funds and avoiding RMD's.  This is all especially useful for those with a lot of wealth outside their qualified accounts. As they'll be in a high bracket even after a Roth conversion, have the funds to pay the taxes outside the account, and will very likely not want or need to use the RMD's anyway (assuming they want to leave a decent chunk to their kids).

This is all well and good, but it got me thinking about the estate tax implications of the traditional vs Roth IRA dilemma.

We all probably would agree that spending down assets outside a tax shelter first is ideal, leaving the shelter in tact for as long as possible (even if that means converting to a Roth...).  What happens, though, when you transfer an IRA to your children, is the entire thing is subject to estate tax (assuming you have a taxable estate), including whatever portion you believe will essentially go towards paying federal income taxes. For instance, if you take someone with $10 million in assets, $3 Million of which are pre-tax qualified account money... If he died tomorrow, he'd have a $10 million estate.  Instead, if he converted to the Roth, and paid $1.2 million or so in income tax with outside-IRA dollars, he not only has eliminated required minimum distributions and effectively inserted (depending on where taxes go in the future) about $1.2 million into a tax shelter, but he has now turned a $10 million estate into a $8.8 million estate.

If his estate would have had to pay tax at 45% on that $1.2 million, his family got to keep $540,000 in estate tax that they would have had to pay.

Of course the Roth could blow up on us, but the idea that this would happen without any kind of warning from congress, or that other taxes wouldn't be going crazy as well, including investment income and estate taxes, seems like a stretch to me. 

And once this Roth is inherited, the kids have to take small RMD's (just as they would have if it was a traditional IRA), but can either keep the rest sheltered or pull it out for whatever they like. 

Of course, most people should be more careful about Roth conversions than doing it all in one year.

I hope someday I have the burden of using these planning considerations for myself. In the meantime, for all you rich sob's, enjoy .

Assuming similar tax rates, that $1.2 million would have left the kids hands anyway in federal income tax, and that is just the present value of the liability... It grows with the value of the account.

The best way to look at an IRA is as an asset with an imbedded liability in it that will grow at the same rate as your assets (once again, assuming similar tax rates over time).

Not being allowed to net that liability against your taxable estate is essentially the equivalent of double taxation.  Not only do you lose the $1.2 million (either now or more later), but you lose the $540,000 of estate tax that you had to pay as a resultif the government essentially not recognizing the liability you're passing along to your kids embedded in the account.

The implied tax of an IRA is on your balance sheet regardless of whether you defer it or just pay it now by converting to Roth.

But by converting to roth, you pay the tax before it has a chance to show up as an asset (which it really isn't) on your estate tax return.

I guess double taxation was the wrong word. It's essentially like if you had a liability on your balance sheet that, for some reason, you couldn't count against your taxable estate.

Might as well pay off the debt!

Make sense yet?  It's not exactly intuitive.

Maybe someone else can give it a try.

MangoMan wrote: The estate tax is inherently double taxation regardless. You pay tax on the income when you earn it, and then pay estate tax on it again when you pass it on at your death. The IRA only temporarily delays this process.

As much as I dislike taxes this is not double taxation. That's akin to arguing that I shouldn't be taxed on the money I earn from my employer because he already paid tax on it. Anytime money moves from person or entity A to person or entity B the argument of double taxation dies.

That said reasonable people can debate the merits of the current tax system. But that particular argument doesn't work. My own feeling is that we need to do away with all sorts of special taxes (and tax breaks). No more estate tax or capital gains tax. The rule should be very simple. If you come into money you did not previously have, then it's income. If you made a killing in the stock market, I'm happy for you. I'm overjoyed. Now please pay your fair share of taxes which rate should not be lower than what my auto-mechanic pays working 50+ hrs a week to provide food and shelter for his family.

If you want to buy a house, that's awesome!. I fail to see why I should subsidize that however. If you gamble and lose money in the stock market you have my sympathies. Again though, I fail to see why I should have to cover your losses via tax breaks.

And yes, if your uncle Bill Gates croaks and leaves you all of his vast fortune, I am happy for you (and a bit envious). But you need to pay the tax on that money you just got.

I don't see what is so complicated about this. Let's do a simpler example.

1. You leave your heirs $15 million in a traditional IRA. This is $10 million above the exempt amount. Your estate will have to pay tax on that $10 million at the rate of 45%, which is a tax bill of $4.5 million. So your heirs get $5 million (estate tax exempt) + $5.5 million (after 45% estate tax), or $10.5 million, all of which is subject to ordinary income taxes when they take it out of the IRA. Let's say they have to pay 40% in income taxes on that, so they end up with $6.3 million after all taxes.
2. You pay taxes to convert the IRA to a Roth. Assume that you pay a 40% tax rate conversion on the $15 million, you end up with an estate of $9 million. Now your estate will incur an estate tax of 45% on $4 million, which leaves your heirs with $5 million (exempt from estate taxes) + $2.2 million (after 45% estate tax), or $7.2 million.

So assuming the tax rates when taking the money out are as indicated, the Roth wins easily.

Ad Orientem wrote:

MangoMan wrote: The estate tax is inherently double taxation regardless. You pay tax on the income when you earn it, and then pay estate tax on it again when you pass it on at your death. The IRA only temporarily delays this process.

As much as I dislike taxes this is not double taxation. That's akin to arguing that I shouldn't be taxed on the money I earn from my employer because he already paid tax on it. Anytime money moves from person or entity A to person or entity B the argument of double taxation dies.

That said reasonable people can debate the merits of the current tax system. But that particular argument doesn't work. My own feeling is that we need to do away with all sorts of special taxes (and tax breaks). No more estate tax or capital gains tax. The rule should be very simple. If you come into money you did not previously have, then it's income. If you made a killing in the stock market, I'm happy for you. I'm overjoyed. Now please pay your fair share of taxes which rate should not be lower than what my auto-mechanic pays working 50+ hrs a week to provide food and shelter for his family.

If you want to buy a house, that's awesome!. I fail to see why I should subsidize that however. If you gamble and lose money in the stock market you have my sympathies. Again though, I fail to see why I should have to cover your losses via tax breaks.

And yes, if your uncle Bill Gates croaks and leaves you all of his vast fortune, I am happy for you (and a bit envious). But you need to pay the tax on that money you just got.

So investors would have to pay taxes at regular income tax rates on gains, and couldn't deduct losses? Exactly why is that fair?

Libertarian666 wrote:

Ad Orientem wrote:

MangoMan wrote: The estate tax is inherently double taxation regardless. You pay tax on the income when you earn it, and then pay estate tax on it again when you pass it on at your death. The IRA only temporarily delays this process.

As much as I dislike taxes this is not double taxation. That's akin to arguing that I shouldn't be taxed on the money I earn from my employer because he already paid tax on it. Anytime money moves from person or entity A to person or entity B the argument of double taxation dies.

That said reasonable people can debate the merits of the current tax system. But that particular argument doesn't work. My own feeling is that we need to do away with all sorts of special taxes (and tax breaks). No more estate tax or capital gains tax. The rule should be very simple. If you come into money you did not previously have, then it's income. If you made a killing in the stock market, I'm happy for you. I'm overjoyed. Now please pay your fair share of taxes which rate should not be lower than what my auto-mechanic pays working 50+ hrs a week to provide food and shelter for his family.

If you want to buy a house, that's awesome!. I fail to see why I should subsidize that however. If you gamble and lose money in the stock market you have my sympathies. Again though, I fail to see why I should have to cover your losses via tax breaks.

And yes, if your uncle Bill Gates croaks and leaves you all of his vast fortune, I am happy for you (and a bit envious). But you need to pay the tax on that money you just got.

So investors would have to pay taxes at regular income tax rates on gains, and couldn't deduct losses? Exactly why is that fair?

Umm your asking the wrong question. The correct question is why should taxpayers subsidize people who choose to play in the world's biggest gambling casino? Why should your income be more sacred than my auto-mechanic's or for that matter my uncle Tom's when he goes to Vegas and actually wins (which he does do occasionally)? When you get tax breaks for that, they have to pay for it.

The capital gains tax (and loss) is one of the most regressive and outrageously unfair tax breaks that's ever been passed.

So this is what it feels like to have a thread hijacked! . Totally kidding. I love the estate tax debate.


Libertarian666,

How do you get my technical explanations so well until we arrive to economics and money!?


And for the record, I agree with Ad's take on taxes, except I think losses should be able to be offset against gains.

moda0306 wrote: So this is what it feels like to have a thread hijacked! . Totally kidding. I love the estate tax debate.


Libertarian666,

How do you get my technical explanations so well until we arrive to economics and money!?


And for the record, I agree with Ad's take on taxes, except I think losses should be able to be offset against gains.

I guess my problem is that I only understand things that make sense.