To Roth, or Not to Roth?

This week Gail answers your questions about inheritance tax, rolling over a (dead) spouse’s retirement account, and offers a lesson for Roth conversion wannabes.

Dear Readers,

If you’ve been salivating over the idea of socking money away in a Roth IRA, but haven’t been able to qualify because of the income limits, mark your calendar for January 1, 2010.

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Congress has just approved a major tax bill that eliminates the income restriction on converting a traditional IRA — comprised of pre-tax contributions — to a Roth IRA. That limit — $100,000 of “Modified Adjusted Gross Income” — meant that many people who had wanted to convert all or part of their traditional IRA to a Roth could not do so.

The attraction of a Roth IRA is that, while contributions are not deductible, withdrawals are tax-free, provided you follow the rules.

Of course, in order to convert your Traditional IRA to a tax-free Roth IRA, you have to pay the income tax on the converted amount. As an inducement, those who make the conversion in 2010 will get to spread out their tax bill over the next ten years. (Congress figures there is so much pent-up demand for IRA conversions, this will bring in billions of tax revenue and help offset reduced revenue from other tax breaks in this bill.)

Is it worth it? There are a number of factors to consider, not the least of which is whether your income tax rate in retirement is likely to be lower than the tax bracket you’re in today. And to get the biggest benefit, you would want to use non-IRA money to pay the tax due. You should also consider how long the money is likely to remain in the Roth; the longer you leave it in, the bigger the potential for tax-free gains.

So, should you consider converting your IRA to a Roth in a couple of years? Probably. For the simple reason that it’s smart to diversify the tax treatment of your assets. Since there is no way to know what the income, capital gains, and dividend tax rates will be in the future, having assets in different types of accounts, gives you flexibility.

If income tax rates are substantially higher when you retire but long-term capital gains rates are still comparatively low, you would favor taking withdrawals that generate capital gains instead of income tax. If both of these rates are a lot higher, but Congress is debating another rate change, you would take withdrawals from your tax-free Roth IRA and wait to see if income and capital gains taxes got reduced.

It’s just a way to hedge your bet in terms of taxes.

Choice is good.


Dear Gail-

I expect to receive an inheritance before the end of this year. What are the tax rules regarding inheritances?



Dear Bruce-

The short answer is that it depends upon the state in which you live.

The “estate” tax is a federal “transfer” tax. That is, it is imposed when property is distributed (transferred) to others after the original owner of the property dies. The dead person’s estate is responsible for paying the estate tax—not the beneficiaries of the property.

Essentially, the tax is based on the value of the decedent’s assets after various expenses are subtracted and a credit is applied. As a result, this year the estate tax does not kick in until someone’s taxable estate exceeds $2 million.

However, while the beneficiary is not responsible for paying the estate tax, you could still owe federal income on the assets you receive. Retirement plans and annuities are typical examples. These are considered “Income In Respect of a Decedent.” This essentially means that the beneficiary owes the same tax that the owner would have had to pay if she/he were still alive.

Since distributions from these accounts are subject to ordinary income tax, if you inherited Grandpa’s traditional IRA, you would have to pay income tax on the withdrawals you make.

In contrast to the federal “estate tax,” which the decedent’s estate is expected to pay, “inheritance tax” is the term most states use to describe the tax they levy when assets pass at death. Bruno Graziano, an attorney and Senior Tax Analyst at CCH, says “The traditional definition of ‘inheritance tax’ is a tax imposed on the recipient” of property they inherit. The tax rate—indeed, whether there is any tax at all—usually depends upon the beneficiary’s relationship to the deceased.

The online version of the Iowa Department of Revenue’s “Inheritance Tax” booklet states that “inheritance tax is a tax on the share going to a beneficiary, and it is the beneficiary who is responsible for payment of the tax.” (Emphasis added.)

There are exceptions. For Iowa residents, property that passes from one spouse to another spouse is exempt from inheritance tax. So are assets that pass to “lineal ascendants” (e.g. parents, grandparents, great grandparents) or “lineal descendants” (e.g. children—both biological and adopted—as well as grandchildren, great grandchildren).

But if you’re a sister, a nephew, an uncle, or the milkman, the state of Iowa wants you to pay your inheritance tax before it legally recognizes you as the new owner of the inherited property. “The relationship between the recipient of the property and the decedent determines the tax rate. The more closely related the recipients is to the decedent, the less the tax.”

Ditto for Pennsylvania: your relationship to the decedent determines both whether you owe any inheritance tax as well as the rate you pay. According to the Pennsylvania Department of Revenue’s Web site, there is no tax on property left to a spouse or to your own child, provided that child is under the age of 21.

However, if you leave assets to your adult (age 21 or older) children, they will be hit with a 4.5 percent inheritance tax. The rate is 12 percent on assets left to sisters or brothers and 15 percent on everyone else.

“There may even be different tax rates depending up on the type of property,” say Graziano. For instance, tangible property such as jewelry, furniture, cars, etc. might be taxed at a different rate than intangible property such as investments.

And, yes, Grandpa’s state of residence can hold you responsible for paying the inheritance tax even if you live in another state. In fact, if you want the farm re-titled in your name, you have to ante up.

Most, if not all, of the states have posted information about their inheritance tax on their Web sites. That’s a good place to start to educate yourself. In addition, if the amount you are inheriting is substantial, you should also consider checking with an attorney in the state where the decedent’s estate will be probated.

Hope this helps,


Dear Gail-

My wife and I have defined contribution plans through out employers. I have a 457 and she has a 403(b). We are listed as the primary beneficiary on each other’s accounts.

If one of us were to die, would the surviving spouse be allowed to rollover the deceased spouse’s retirement account into his or her own, or would that money have to be withdrawn and the taxes paid on it?

Thank you,


Dear John,

The first place to start is by reviewing the rules that govern how each of your retirement plans operate. These are spelled out in what’s called the “plan document.” As a participant in a company-sponsored retirement plan, you are entitled to a copy of this. However, you might find your answers in the “Summary Plan Description” (SPD), a shorter version of the plan document that is written in less legalese and focuses specifically on the rights and responsibilities of plan participants and their beneficiaries.

As you may be aware, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made it possible to merge retirement accounts that, up to then, had to be kept segregated. In other words, if you are a public school teacher with a 403(b) plan who decides to take a job in the private sector where you are offered a 401(k), theoretically it is now possible to roll the money in your 403(b) into your new 401(k) account.

I stress this is “theoretical” because, while federal law allows retirement plans to do this, nothing says they must. Most, in fact, do not for the simple reason that it adds complexity and requires additional recordkeeping. When you’re talking about retirement plans, complexity = higher costs.

But you’re not talking about rolling your own account from one employer-sponsored plan to another. Rather, your question revolves around whether someone else—a spouse—can roll your retirement account in theirs, which puts a new spin on things.

None-the-less, Section 402(c)(9) of the Internal Revenue Code states that anything the owner of a retirement plan is legally allowed to do with his/her account, a surviving spouse can do. So this seems to support your idea.

David Wray, president of the Profit-sharing 401(k) Council of America, agrees. “It’s our opinion that the surviving spouse can rollover the inherited account into their own plan — if their plan permits it.”

But he adds, “It’s not common.”

Frankly, a better option would be to roll the retirement account of the deceased spouse into an IRA in the surviving spouse’s name. For starters, the surviving spouse would have more control over how the money is invested. Instead of being restricted to a limited number of mutual funds offered by the surviving spouse’s plan, s/he has a much broader menu of investment options: thousands of mutual funds, individual stocks, bonds, and even certain gold coins.

In addition, if you and your wife have children or other beneficiaries you’d like to leave assets to at the second spouse’s death, these beneficiaries will generally have greater flexibility if they inherit those assets from an IRA as opposed to a company-sponsored retirement plan. For instance, any non-spouse beneficiary--child, grandchild, sibling, etc.--who inherits an IRA can elect to “stretch” out his/her Required Minimum Distributions over his/her life expectancy instead of emptying the IRA all at once and paying the tax on a lump sum distribution.

Avoiding a big one-time tax bill is only part of the “stretch” story. If a beneficiary extends the required withdrawals over her/his life expectancy--which could be 70 years or more in the case of a young child--the assets in the IRA have the potential to continue to grow and compound for decades. This can result in significantly more money ending up in the hands of your beneficiary.

On the other hand, if a non-spouse beneficiary inherits the money directly from a 401(k), 403(b), 457 or other type of defined contribution plan, stretching out the mandatory withdrawals is usually not an option; the money must be withdrawn within one to five years after the account owner dies. Again, the answer lies in the summary plan description.

I suggest that you and your wife contact your respective human resources departments and request copies of the SPDs that govern each of the retirement plans you have participated in. You might also want to seek advice from an experienced financial advisor or lawyer. Making a mistake with retirement money can be costly.

Best wishes,


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