Roth IRAs and Potential Estate Tax Savings

A recent column, “IRS Postpones Roth Catch-Up Retirement Contributions Until 2026,” discussed the virtues of the Roth TSP and the Roth IRA with respect to federal and state income tax savings for federal retirees and their beneficiaries. That column discusses that when an employee or a retiree converts a traditional IRA to a Roth IRA, income taxes have to be paid by the traditional IRA owner. The income tax paid on the conversion results in tax-free income when qualified withdrawals are made from the Roth IRA, both by the Roth IRA owner and the Roth IRA beneficiaries.

When any individual pays a bill for another individual, the amount of the bill payment is considered a “gift”. However, in the case of a traditional IRA conversion to a Roth IRA, the amount of taxes paid by the traditional IRA owner (on behalf of future Roth IRA beneficiaries) does not count as a gift for federal or state estate or federal gift tax purposes.

While qualified withdrawals from the Roth TSP and the Roth IRA are federal and state income tax-free, the Roth TSP and Roth IRA are potentially subject to federal and state estate taxes.

This column discusses how converting traditional IRAs, and/or rollovers of traditional TSP to traditional IRAs (which are then converted to Roth IRAs) can result in estate tax savings for federal retirees. This is especially true for TSP participants and Roth IRA owners who are residents of states which have low state estate tax thresholds.

The federal estate tax exemption (at which point the federal estate tax kicks in) during 2023 is $12.92 million per person ($25.84 million for a married couple) and increases a little each year. This means that the estates of few federal employees are potentially subject to federal estate tax. Note, however, that unless Congress votes to keep the current high federal estate tax exemption (voted into law as part of the Tax Cuts and Jobs Act of 2017), the federal estate tax exemption will decrease to $7 million on January 1, 2026.

While the majority of states have no estate taxes, most of the states that have state estate taxes have much lower estate tax exemption amounts compared to the federal estate exemption amount. That means in these states those state residents who have significantly large estates (including large Roth IRA balances) could be potentially subject to huge state estate tax bills.

An example of a state that has a state estate tax is New York state. During 2023, the New York state estate tax has an exclusion of $6.58 million. Note that unlike federal and state income taxes which have what are considered “progressive” tax rates, the federal and state estate tax is a “cliff” tax.

This means that once an individual’s estate value exceeds the exclusion amount, the estate tax is imposed on the total value of the estate and not just on the value of the estate in excess of the exclusion amount. New York state, like several states with estate taxes, taxes on the total value of the estate. This is commonly known as a “cliff” tax.

The following example illustrates:

William, age 73, was a New York resident when he died early in 2023. His estate is valued at $6.68 million, $100,000 larger than the current New York state estate tax exemption. The New York state estate tax bill is $252,516 on an estate valued at $6.68 million. The sizeable New York estate tax is due to the fact that the $100,000 excess over the $6.58 million estate exclusion results in a “cliff” tax imposed on the entire $6.68 million estate

What action could have William taken to eliminate the entire $252,516 state estate tax? Suppose William before he died had decided to convert a traditional IRA worth $200,000 to a Roth IRA, and assume a combined federal and New York state tax income rate of 50 percent. That would require William to pay a total of $100,000 in federal and state income taxes in order to convert the $200,000 traditional IRA to a Roth IRA. But paying the $100,000 in total taxes to the federal government and to New York state would reduce the estate by $100,000, lowering the value of William’s estate to $6.58 million and thereby eliminating a potential $252,516 New York state estate bill.

The ultimate result is that William’s heirs will be inheriting a Roth IRA that is both income tax-free and estate tax-free, federal and state. There is also good news for William had he lived. His lifetime taxable income will be reduced as a result of lower RMDs. This is because $200,000 of his traditional IRA was converted to a Roth IRA which is not subject to required minimum distributions.

Two states – Massachusetts and Oregon – have a $1 million state estate tax exemption. This rather low estate tax exemption can generate a much higher state estate tax. But converting traditional IRAs to Roth IRAs and paying the federal and state income taxes due could potentially lower the Roth IRA owner’s estate value to the extent that no federal or state estate taxes will be due, similar to the example in which William’s estate owes no federal or New York estate taxes.

Those federal employees and retirees who are residents of states with state estate taxes and whose state estate tax exemptions are low, are advised to talk to their tax advisors and estate attorneys in order to determine whether they are potentially subject to state estate taxes and if they are, what needs to be done to minimize the chances of their estates paying any amount of money resulting from their state estate tax liability.