Excluding pensions and defined benefit retirement plans, there are two basic schemes for retirement accounts: one in which dollars are contributed pre-tax, grow tax deferred and are subject to income tax on withdrawal, and the other, where dollars are contributed after-tax, grow tax free and are not subject to tax upon withdrawal. Why does all of this matter?
For purposes of this post, I’ll refer to the first group as Traditional IRAs (the pre-tax contribution scheme also includes SIMPLE, SEP, and 401(k) plans) and the second group as Roth IRAs. Although people will argue over the watercooler that the Roth or Traditional IRA is better, the difference is largely academic—for most individuals.
The reason for this is some fifth grade math that most of us forgot—the “Associative Property of Multiplication” (click here for an explanation). As a result of this sneaky property, the only real way to benefit from one plan over the other is a different tax rate at contribution than at withdrawal OR another tax provision comes into play.
So, if the difference is academic, then why does this matter? Historically Roth IRAs were limited to individuals with lower incomes. Now, however, almost anyone can rollover a Traditional IRA into a ROTH IRA. The estate tax only impacts affluent individuals and it is one of those other tax provisions that changes the entire game.
If, for example, your estate will be subject to the estate tax (generally, this requires your estate to exceed the applicable exclusion, which in 2016 is $5,450,000), then you may be able to save on taxes by converting your Traditional IRA to a Roth IRA. Accordingly, now that there is no income limitation on the conversion of a Traditional IRA to a Roth IRA, conversions are worth serious consideration.
Please keep in mind that this is a very abbreviated summary. There are numerous pitfalls that this post completely omits. Estate planning with retirement assets is tricky, but there are serious tax saving opportunities and you should consult with a tax advisor if you think you might benefit from this or other similar strategies.