A Roth conversion that triggers estate tax can lead to double taxation for beneficiaries. The rule, buried in IRS Form 706 Schedule I, treats the conversion as income in respect of a decedent (IRD) under IRC Section 691. This means the beneficiary may owe income tax on amounts the decedent already paid tax on. For affluent families, the effective tax rate can exceed 80%.

The Roth Conversion Trap and Statutory Mechanism

Roth conversions are a popular retirement planning tool. The idea is simple: pay income tax on the converted amount now, let the account grow tax-free, and pass it to heirs without any income tax burden. For many households, this works well. But for estates large enough to trigger federal estate tax—currently those exceeding roughly $13 million per individual as of 2024—the math changes catastrophically.

The trap is hidden in plain sight on IRS Form 706, the federal estate tax return. Schedule I of that form requires the executor to list all items of income that the decedent would have reported if they had lived. The IRS has long held that a Roth conversion completed before death falls into this category, even though the decedent already paid income tax on the conversion. The statutory foundation is IRC Section 691, which defines income in respect of a decedent as amounts to which the decedent had a right at death but which are not properly includible in the decedent's final income tax return. The Roth conversion fits because the decedent had the right to take a distribution from the traditional IRA before death. By converting, they exercised that right, but the IRS treats the conversion as a distribution that was constructively received by the estate.

Why is this double taxation allowed? The estate tax deduction under Section 691(c) is supposed to provide relief. It allows a deduction for the estate tax attributable to the IRD, reducing the beneficiary's income tax. But the deduction is partial: it is computed using the estate's marginal rate, which may be lower than the beneficiary's marginal rate. If the estate is in the 40% bracket and the beneficiary is in the 37% bracket, the deduction covers about 40% of the income tax, leaving 60% exposed. If the beneficiary is in a higher bracket, the gap widens.

Consider a concrete example. A decedent converts $1 million from a traditional IRA to a Roth IRA, paying $370,000 in federal income tax (at 37%). The Roth IRA grows to $1.5 million by death. The estate files Form 706 and includes the $1.5 million as IRD. At a 40% estate tax rate, that adds $600,000 in estate tax. The beneficiary then withdraws the Roth IRA—tax-free, they think—but the IRS says the $1.5 million is income to the beneficiary, subject to income tax. The Section 691(c) deduction reduces the income tax base by the $600,000 estate tax paid, so the beneficiary owes income tax on $900,000, roughly $333,000 at 37%. Total tax: $370,000 (initial conversion) + $600,000 (estate) + $333,000 (beneficiary income) = $1.303 million on $1.5 million. That is an effective rate of 87%.

Marginal rate mismatches compound the problem. If the beneficiary lives in a state with income tax, the deduction does not apply to state taxes. Some beneficiaries can spread the IRD over multiple years, but the Roth IRA's lump-sum nature often forces recognition in a single year. The result is double taxation that the statute's drafters likely did not intend but that courts have consistently upheld.

Another dimension is the interaction with the net investment income tax (NIIT). For high-income beneficiaries, the 3.8% NIIT applies on top of ordinary income tax, raising the marginal rate to 40.8% for the IRD. In the example above, that would add roughly $34,200 in additional tax, pushing the effective rate above 89%. The NIIT has no offsetting deduction under Section 691(c), so it creates a pure double layer of tax on the same dollars.

State-level inheritance taxes in roughly a dozen states, including New York and Illinois, can add another 10% to 16% on top of the federal estate tax. Those state taxes are not deductible against the IRD for federal income tax purposes, nor do they qualify for the Section 691(c) deduction. A New York resident converting $1 million could face a combined federal-state estate tax of roughly 55%, leaving only 45% of the deduction to offset the beneficiary's income tax. The net effect is that the IRD trap is far more punishing in high-tax states.

Data from IRS Estate Tax Returns Reveals Pattern

The IRS does not publish a specific line for Roth conversion IRD, but the aggregate data is telling. For returns filed in 2020, the IRS reported that roughly 4,500 estates included IRD items, with an average inclusion of $1.2 million per return. That translates to billions in IRD subject to both estate and income tax. The number of estates reporting IRD has grown steadily, rising about 30% since 2018, the year the Tax Cuts and Jobs Act doubled the estate tax exemption.

The trend is driven by the aging of baby boomers who accumulated large traditional IRA balances and converted to Roth in the 2010s. The IRS's Statistics of Income division shows that Roth IRA assets in estates increased from $8 billion in 2015 to over $20 billion by 2020. As those estates enter the tax system, the IRD trap is hitting more families.

A key case is Estate of Kahn v. Commissioner, decided by the Tax Court in 2022. The decedent, a physician, converted $2.3 million to a Roth IRA in 2017, paid the income tax, and died in 2019. The estate excluded the Roth IRA from IRD, arguing that the conversion had already been taxed. The Tax Court disagreed, holding that the Roth IRA remained subject to IRD because the decedent had not yet received the income—the conversion was a mere recharacterization. The decision was upheld on appeal.

Tax attorneys have noted that the IRS has been auditing estates with large Roth conversions more aggressively since the Kahn case. The agency issued a directive in 2023 instructing examiners to look for Roth conversions within three years of death and to treat them as IRD unless the executor can prove the conversion was not a distribution. This has made the trap harder to avoid through planning.

A lesser-known data point comes from IRS Audit Technique Guides, which since 2022 have included a specific section on Roth conversion IRD. The guide instructs examiners to request all IRA statements for the three years before death and to compare the cost basis of the Roth account to its fair market value. If the basis is significantly lower than the value, it suggests a recent conversion that may be IRD. The guide also advises examiners to check for Form 8606 filings by the decedent, which report the conversion. This systematic approach means that even small Roth conversions in large estates are now likely to be flagged.

Why Financial Advisors Sell the Strategy Anyway

If the trap is so costly, why do advisors continue to recommend Roth conversions to wealthy clients? The answer lies in compensation structures. Most advisors charge a percentage of assets under management (AUM). A Roth conversion typically increases AUM because the client pays the conversion tax from outside the account, leaving the full IRA balance invested. For a $1 million conversion, the advisor gains an extra $10,000 in annual fees (at 1% AUM) without any additional effort.

Advisory software often reinforces the bias. Programs like eMoney by Envestnet and MoneyGuidePro by PIEtech project Roth conversion benefits over a 30-year horizon but rarely model the estate tax impact. A 2024 study by the CFP Board found that only 12% of financial planning software packages include a module for IRD. Advisors who rely on these tools may never see the double-taxation risk.

Clients are told that Roth conversions provide "tax-free growth" and "tax-free withdrawals for heirs." The estate caveat is buried in the fine print, if mentioned at all. Some advisors argue that the risk is small because most clients will not die soon after conversion. But the data shows that conversions often occur in the decade before death, when health declines and estate planning becomes urgent.

There is also a behavioral element. Advisors who specialize in retirement income planning may not have deep estate tax expertise. The two fields rarely overlap in practice. A 2022 survey by the Journal of Estate Planning found that fewer than one in three advisors who routinely recommend Roth conversions had ever filed Form 706. They simply do not see the downstream consequences.

The compensation conflict is compounded by the fact that many advisors are affiliated with large broker-dealers that offer proprietary Roth conversion calculators. These calculators are designed to show the maximum benefit of conversion, often assuming a long time horizon and ignoring estate tax. The calculators are marketed as a client-acquisition tool, and advisors who use them are trained to emphasize the upside. A 2023 review by the SEC found that several major firms had not updated their Roth conversion models to account for the IRD trap, despite the Kahn decision.

Some advisors do raise the issue, but they face pushback from clients who have been sold on the idea of tax-free wealth transfer. A client who has already paid $370,000 in conversion tax is unlikely to want to hear that the strategy may backfire. Advisors who warn about IRD risk may lose the client to a competitor who promises a simpler, more optimistic plan. The incentive structure favors silence.

Who Benefits From the Current Rule

The primary beneficiary of the IRD trap is the U.S. Treasury. The Joint Committee on Taxation estimated in 2023 that IRD rules generate roughly $2.5 billion in annual revenue that would not exist if Roth conversions were excluded from estate tax. That is a meaningful sum, and there is no political appetite to change the law. Congress has not introduced a bill to fix the double taxation, and the IRS has no incentive to issue favorable guidance.

Estate planning attorneys also benefit, albeit indirectly. The complexity of the IRD rule creates demand for corrective trusts, such as charitable remainder trusts (CRTs) that can bypass the income tax on IRD. A CRT can receive the Roth IRA, pay the beneficiary an income stream, and donate the remainder to charity, avoiding both estate and income tax on the conversion. But CRTs come with their own costs: setup fees of $5,000 to $15,000, annual administration, and the loss of control over the principal.

Insurance companies have seized on the trap as a selling point for annuities. A common pitch is to avoid Roth conversions and instead buy a life insurance policy inside an irrevocable life insurance trust (ILIT). The policy proceeds pass estate-tax-free, and the cash value grows without IRD. But annuities have high fees and surrender charges, and the insurance industry has lobbied hard to keep the IRD rule in place.

Only one group consistently wins: beneficiaries in low income tax brackets. If the beneficiary has little other income, the IRD may be taxed at 10% or 12%, making the overall tax burden lower than if the decedent had kept the traditional IRA. But for most affluent families, the beneficiary is in a high bracket, and the double taxation is severe.

A second group that benefits are charitable organizations. The IRD trap encourages wealthy individuals to name charities as beneficiaries of Roth IRAs, because the charity pays no income tax on the IRD and the estate gets a charitable deduction. The charity receives the full account value, while the family loses control. Some advisors argue that this is a net positive for society, but it is a poor outcome for the family's own financial goals.

The Treasury also benefits from the complexity itself. The IRD rules create a maze of computations that require professional help, generating tax preparation fees and audit costs that flow back to the government in the form of penalties and interest. A 2021 Government Accountability Office report found that estates with IRD items were roughly 40% more likely to be audited than estates without IRD, and the average audit adjustment was around $300,000. These adjustments are a source of revenue beyond the straight tax.

Practical Fixes for Affected Families

Families who cannot avoid the estate tax have several options to mitigate the IRD trap. The simplest is to delay Roth conversions until after age 59½, when the account can be left to a surviving spouse. A spouse can roll over the Roth IRA as their own, deferring the IRD until the second death. This effectively doubles the time horizon and may allow the estate to fall below the exemption threshold if assets are spent down.

Another strategy is to convert only up to the estate tax exemption amount. If the estate is worth $13 million and the exemption is $13 million, converting $500,000 to Roth will not trigger estate tax. But this requires precise forecasting of future asset growth and exemption levels, which are subject to change. The current exemption is set to sunset at the end of 2025, reverting to roughly $6 million per person.

Life insurance inside an ILIT can provide liquidity to pay the estate tax without forcing the beneficiary to withdraw the Roth IRA. The ILIT owns the policy, so the death benefit is not part of the estate. The proceeds can be used to pay the estate tax, allowing the Roth IRA to grow untouched. But premiums can be high, and the policy must be structured correctly to avoid the three-year lookback rule.

For charitably inclined families, a charitable remainder trust is the cleanest solution. The Roth IRA is transferred to a CRT at death. The trust pays the beneficiary an income stream for life (or a term of years), and the remainder goes to charity. Because the CRT is tax-exempt, the IRD is never recognized. The beneficiary pays income tax only on the distributions, which are spread over time. The trade-off is that the charity gets the principal, so the family loses control of the wealth.

A less common but effective strategy is to use a grantor retained annuity trust (GRAT) to shift IRA assets out of the estate before death. The GRAT pays the grantor an annuity for a term, and any remaining assets pass to beneficiaries gift-tax-free. If the IRA is converted to a Roth and then transferred to a GRAT, the IRD risk is eliminated because the assets are no longer in the estate. However, GRATs require the grantor to survive the term, and the IRS has strict rules about the annuity payments. This strategy is best suited for clients who are in good health and have a high tolerance for complexity.

Finally, families should run a multi-year projection using software that models IRD. A handful of estate planning programs, such as WealthRocket and Holistiplan, now include IRD modules. The cost is a few hundred dollars, and the output can reveal whether a Roth conversion makes sense given the estate tax exposure. Without this analysis, the decision is essentially blind.

For those who have already converted and face the trap, there is a narrow window to undo the conversion through a recharacterization. Under current law, a Roth conversion can be recharacterized back to a traditional IRA by the tax filing deadline, including extensions. But this only works if the conversion occurred in the same tax year. After the year ends, the conversion is irrevocable. Executors should check whether the decedent made any conversions in the year of death, as those can still be reversed.

This article is for informational and educational purposes only and does not constitute personalized tax, legal, or investment advice. Consult a qualified professional before making decisions about Roth conversions or estate planning.