Originally created as a savings tool for retirement, the Roth IRA was established by the Taxpayer Relief Act of 1997. And like its cousin the Traditional IRA, Roth IRAs allow for tax- deferred growth but with the added advantage of tax-free qualified distributions and no required minimum distributions after age 70 ½. These features allow Roth IRAs to be an efficient and effective wealth transfer tool when establishing a legacy is paramount and cash flow and tax management are secondary considerations.
As a retirement income tool, Roth IRAs are tax-efficient allowing you to make distributions of your contributions and any growth fully tax-free after reaching 59 ½. What is often overlooked is the treatment of the Roth IRA after the owner dies and the account is inherited. For traditional IRAs, beneficiaries must start making distributions from the account and all distributions are fully taxed as ordinary income. In most cases the distributions can be stretched out over the beneficiaries lifetime, and if the beneficiary is young, the longer the distributions are stretched out, the less the tax burden. For Roth IRAs beneficiaries are also required to make minimum distributions, but these distributions are tax-free.
Because of this tax treatment for beneficiaries, if you hold significant IRA assets, you may consider making Roth conversions for the purpose of transferring those assets to heirs tax-free. To fully utilize Roth IRAs as an estate planning tool, you should be certain you will not need to use the Roth IRA for your own cash flow needs and are in a relatively low tax bracket because it will require realizing income by utilizing Roth conversions to convert Traditional IRA assets to Roth IRA assets.
Let’s consider a couple: Husband 87, and wife 82. With total portfolio assets of $1.79 Million with just over half of their assets in Traditional IRA accounts. Their expenses are covered from RMD and Social Security. With no need to draw from their Roth IRA, they would like to create a legacy for their children and are willing to pay some additional taxes if it achieves their goal.
Assuming end of plan age of 99, by converting a total of $200,000 over five years, the couple was able to create $317,000 of additional tax free inheritance by the end of the first death, and $395,000 by the second death.
To manage taxes, the couple opted to convert a total of $200,000 over five years being mindful to stay in the 22% marginal tax bracket.
The total upfront “cost” in additional taxes equates to $38,738 above what would have been paid in taxes without Roth conversions. A secondary benefit is reducing future RMDs because a result of Roth conversions is reducing the size of the traditional IRA. Over the course of their lifetimes their cumulative tax liability was actually reduced by $10,600.
In the right situation Roth IRAs are useful retirement income tools, but also can be utilized as a powerful estate planning strategy, creating a tax-free inheritance.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. Links are being provided for information purposes only. Raymond James is not affiliated with and does not endorse, authorize or sponsor any of the listed websites or their respective sponsors. Raymond James is not responsible for the content of any website or the collection or use of information regarding any website's users and/or members. Any opinions are those of the author and not necessarily those of RJFS.