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Estate Planning Benefits of Roth IRA
Much of the hoopla about Roth individual retirement accounts has died down since the
special tax break for converting from a traditional IRA to a Roth expired after 1998.
One aspect of Roth IRAs that was often overlooked amid the hoopla is the estate
planning benefits of Roths, especially for older taxpayers who want to pass on as much
of their estate as possible to their heirs.
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One of the major estate tax benefits for Roth IRAs is that unlike traditional IRAs you
don’t have to start taking out annual minimum distributions beginning at age 70 1/2.
By leaving the money in the Roth to keep growing tax-deferred until your death, you’ll
leave a larger amount to your heirs than with a traditional IRA. Moreover, if you or
your spouse earn income beyond age 70 1/2, you can continue contributing up to $2,000
a year in after-tax money to the Roth account—something you can’t do with a regular
IRA.
Your heirs also get a second tax break. Not only do they receive a larger IRA account
at your death, they don’t have to pay income taxes on the eventual distributions from
the account. Heirs pay income taxes (federal, and possibly state and local) on
distributions from traditional IRAs. Distributions from Roth IRAs are tax free as long
as the account has been open and holding assets for at least five years, and the owner
is at least age 59 1/2. Generally, the distributions also may be free of income tax,
regardless of age or holding period, as long as the withdrawals don’t total more than
the contributions.
One thing that doesn’t change with the Roth is that, like other IRAs, it will be
included in your estate and subject to estate taxes if your estate’s value is high
enough ($675,000 in 2000). But your heirs will appreciate the fact that the remaining
account assets won’t be further whittled away by income taxes.
They’ll also appreciate another fact about Roth IRAs. Assume a typical situation where
a husband owns a traditional IRA and names his wife as beneficiary. Minimum
distributions from the IRA are based on the joint life expectancy of the couple in
order to minimize the amount of the annual distributions. If the husband dies before
his wife, she inherits the IRA and makes withdrawals based on her life expectancy. She
in turn might name a daughter as beneficiary, assuming the IRA custodian allows her
to, which some don’t. When she dies, the daughter must take out any remaining money
within five years or over the wife’s life expectancy, assuming she was not
recalculating her life expectancy.
The problem with the traditional IRA arises if the wife dies before her husband. The
husband isn’t allowed to change beneficiaries of a traditional IRA once he’s started
the minimum required distributions. When he dies, the daughter will be required to
take distributions over the father’s remaining life expectancy, assuming he didn’t
recalculate.
With a Roth IRA, on the other hand, the father can rename his daughter as beneficiary
because he doesn’t have any minimum distribution requirements. When she inherits the
IRA, she must start taking withdrawals by December 31 of the year following her
father’s death in order to stretch those withdrawals out over her life expectancy;
otherwise the five-year rule applies.
Now the power of the Roth really becomes apparent to the daughter. First, the
accumulation of the Roth is larger than what it would have been under a traditional
IRA. Second, the daughter can stretch the distributions out over a long time and thus
the Roth generates more total income. Third, she doesn’t have to pay income taxes on
the distributions, leaving her more money than from similar-sized taxable distributions from a regular IRA. Leaving the Roth to grandchildren is yet more
powerful, because of their longer life expectancy.
These benefits are why many financial planners recommend that even older IRA owners
look at the idea of converting regular IRAs into Roths. Even taking into account the
need to pay income taxes on the amount converted to a Roth, the heirs will likely come
out ahead. Keep in mind that you can’t convert in a year in which your modified
adjusted gross income is over $100,000, but that’s usually less of an issue for most
retirees.
July 2000— This column is produced by the Financial Planning Association, the
membership organization for the financial planning community.
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