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Roth IRAs: A Great Estate Planning Vehicle

The reason: Investments held in a Roth IRA are allowed to build up federal-income-tax-free. Later on, you can take federal-income-tax-free withdrawals. Obviously, a zero tax rate is the best rate going.

In addition to being great tax saving tools for retirement, Roth IRAs also provide tremendous estate planning advantages -- especially if you can get a large portion of your wealth into an account.

Unfortunately, getting lots of money into a Roth IRA is not so easy. It can take many years of annual contributions. However, there's also one very quick way -- by converting an existing traditional IRA or SEP account into a Roth IRA. There are no limitations on the size or number of converted accounts. Naturally, under tax law, there is a price for allowing you to jump start your Roth IRA savings program with a conversion. Even so, it may be worth the price.

Roth Conversion Basics

A Roth conversion is treated as a taxable distribution from your traditional IRA. In other words, you're deemed to receive a taxable cash payout from your traditional IRA with the money going into the new Roth account. So the conversion triggers a current income tax bill. In most cases, however, this negative factor is outweighed by the following positive factors.

  • You don't have to pay the 10% premature withdrawal penalty tax on the deemed distribution that results from the Roth conversion transaction. This is true even if you're under age 59 1/2 when the conversion takes place.
  • Your conversion tax bill may be significantly lower, depending on the future fate of tax rates. Some people believe the tax rates we have today could be the lowest rates we'll see for the rest of our lives. No one knows, of course, but now could be a good time for a Roth conversion.
  • The value of the traditional IRA (or IRAs) you want to convert may still be down because of poor investment performance in recent years. However, a lower account balance means a lower conversion tax bill, which is a good thing.

Now for the Estate Planning Angle

The usual reason for converting a traditional IRA into a Roth account is to earn tax-free income that will be withdrawn after age 59 1/2 to help finance your retirement. But if you don't really need the money for retirement, there's another less-publicized advantage to converting. Let's say you would like to pass along as much wealth as possible to your heirs. If so, a Roth conversion transaction can be a great estate planning technique for you.

Don't misunderstand. Roth IRA balances are not exempt from the federal estate tax (nor are traditional IRA balances). However by paying the up-front Roth conversion tax bill, you effectively prepay your heir's future income tax bills while reducing your taxable estate at the same time. And this prepayment of income tax doesn't result in any gift tax or diminish your federal gift tax exemption which for 2019 is $11.40 million (up from $11.18 million in 2018).

But there is even more to pass on to your heirs. A big advantage of Roth accounts is they are not subject to the required minimum distribution rules that apply to traditional IRAs. These rules force the account owner to begin liquidating his or her IRA after turning age 70 1/2. Of course, this means Uncle Sam and state tax collectors take their cut in the form of taxes on the distributions. When you don't need the IRA money, being forced to take these required minimum distributions and pay the resulting income taxes can be pretty costly.

But converting a traditional IRA into a Roth account stops required minimum distributions. Once a conversion is complete, you are free to leave the account balance untouched and accumulate as many tax-free dollars as possible to pass along to your heirs.

However, the required minimum distribution exemption ends when you die. At that point, the Roth IRA falls under a set of the required minimum distribution rules that apply to all inherited IRAs (traditional and Roth). If your heirs are disciplined enough to take only the annual required minimum distribution amounts from the inherited Roth IRA, the account liquidation process can be strung out for many years, as the following example illustrates.

What happened in this example? In effect, the husband and wife took advantage of the Roth IRA rules to establish a nice federal-income-tax-free annuity for their daughter.

For this planning technique to work as it does in the above example, you must take four steps:

Step 1 - Designate your spouse as the Roth IRA beneficiary before you die.
Step 2 - After your death, your spouse must treat the account as his or her own by re-titling it in his or her name.
Step 3 - Your spouse must also name your child as the new Roth IRA beneficiary.
Step 4 - Finally, your child must begin taking annual required minimum distributions by no later than December 31 of the year following the year of your spouse's death. Otherwise, your child will be required to liquidate the inherited Roth IRA after only five years, which would end the tax-free strategy prematurely.

As you can see, a Roth IRA can be a great estate planning vehicle. However, before implementing this strategy, get professional advice about the conversion tax consequences and the estate planning considerations.

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