You may already know the benefits of a Roth IRA in planning for your retirement. However, it is also an equally effective estate planning tool. As a Houston estate planning and probate lawyer, I don’t offer financial or investment advice to my clients, but I often do explain to clients the benefits of a Roth IRA and the tax implications of converting a traditional IRA to a Roth IRA. In particular, if older people convert a traditional IRA to a Roth IRA, it may save on estate taxes and eliminate the income tax their heirs or other beneficiaries would otherwise have to pay when taking withdrawals from an inherited regular IRA. While this may sound to good to be true, it can work. Here’s how:
The first benefit of a Roth IRA is that there are no minimum withdrawal requirements. With traditional IRAs, the owner must begin taking withdrawals in the year he or she turns 70 1/2. However, with a Roth, you can let the balance grow for the rest of your life without taking any withdrawals, which can dramatically increase the amount of money that ultimately passes to your chosen beneficiaries. Once you convert from a traditional IRA to a Roth IRA, you no longer have any mandatory withdrawal requirements (although if you convert after you turn 70 1/2 you will still have to take one final mandatory distribution). As mentioned below, after you die, the beneficiaries you designate will be required to take minimum distributions each year.
When you convert a traditional IRA to a Roth IRA, you will have to pay tax on the accumulated earnings as well as the amount of tax-free contributions that you have made in the past. The reason for this is that the conversion is treated as a taxable withdrawal from the traditional IRA followed by a nondeductible contribution to a Roth IRA. If you can afford to pay the tax out of non-IRA assets, this might not be so bad. By paying the tax at the time of conversion, you are basically prepaying income tax that your heirs would otherwise pay later without using any of your estate or gift tax exemption amount ($5.43 million per individual in 2015). This also has the effect of reducing your estate, which is good if you are fortunate enough to be one of those who has an estate large enough to be concerned about estate tax.
After you die, your beneficiary (or beneficiaries) will inherit the Roth IRA and will have to begin taking mandatory distributions from the IRA. The beneficiary will not have to pay income tax on the distributions as long as the Roth was opened for more than five years as of the withdrawal dates. If the beneficiary can afford to leave the assets in the IRA untouched (other than the required distributions), the assets in the IRA can continue to grow tax-free for years. This can continue as long as the money lasts, which assuming the assets are wisely invested, could be several generations.
The conversion strategy discussed above is not without risk. For this strategy to work, there are two things that need to happen. First, the tax rules for IRAs must remain the same as they are now. With these rules being subject to the whim of an unpredictable Congress, you will want to make sure the rules still apply before making the decision to convert. Second, you must be confident that (a) you won’t need the money while you are alive, and (b) your heirs will largely leave the balance of the IRA untouched, except for the required minimum distributions. Essentially, you are taking a big tax hit up front in order to provide a tax-free annuity for your beneficiaries in the future. If the above assumptions don’t hold up, then the conversion may not be an attractive option.
As with any decision impacting your taxes, finances, or estate, it is a good idea to speak with your financial adviser and estate planning attorney before deciding whether converting to a Roth IRA is a good fit for your Houston estate planning needs.
Reference: Bill Bischoff, Estate Planning with a Roth IRA, MarketWatch, Feb. 11, 2015