Retirement Planning and the Roth IRA

However, you may not know that a Roth IRA can also be a wonderful estate planning tool. Even if you are at (or after) retirement age – it still can make sense to convert a regular IRA into a Roth account. In so doing, you can effectively reduce estate taxes (by lessening the size of your taxable estate due to the payment of the conversion tax) and eliminate income tax your heirs might pay on withdrawals from an inherited regular IRA. You can also extend the tax-free earning capability of the Roth IRA many years into the future. It’s a great way to set up a long-term tax-free annuity for your heirs in a cost effective manner.

Minimum Withdrawals Are Eliminated

Roth accounts are not subject to minimum-withdrawal rules that apply to regular IRAs. Regular IRA rules require you to drain you regular IRA the year after you turn 70.5. You are required to pay the IRS and you state tax collector for any gains or even principle that was previously deducted. Not a pleasant thought.

When a regular IRA is converted into a Roth, this requirement is eliminated. If you are a single or joint filer with adjusted gross income under $100,000, you can avoid being forced to withdraw funds. You can leave the Roth account balance untouched and accumulate as many tax-free dollars as you want for your estate. If you convert after age 70.5, you have to take one final minimum withdrawal for the conversion year. Whatever is left in the regular IRA can then be converted to a Roth account.

Taxes!

Yes, of course! You will pay taxes on any accumulated earnings and tax-deductible contributions when you make the Roth conversation. Ideally, you will want to pay the tax out of non-IRA assets. Don’t despair – you are effectively prepaying income taxes for your heirs without owing any gift tax when you pay the conversion tax. Lastly, prepaying the income taxes reduces the size of your taxable estate.

Your Heirs

After your death, your spouse can treat the IRA as his or her own; thus have no required minimum distribution (RMD). However, if/when transferred to your children upon spouses’ death, your heirs will have to take RMD based on their life expectancy. However, of course, they will not owe income tax on withdrawals from the inherited Roth account. If your child does not need the money right away, he or she can take the minimum required distribution and thus postpone withdrawals over time and continue to earn tax-free income on the account balance.

Risks and Rewards

If none of the above issues troubles you, then conversion is definitely worth considering. Tax law provisions encourage more and more retirement age folks to convert from regular IRAs to Roth accounts.

Roth IRA Conversion Example:

Let's assume you are a 70-year-old male with a regular IRA. You convert the account into a Roth IRA and live another eight years enjoying the tax-free states of the account. All funds remain intact in the account. The wife is designated as the beneficiary of the Roth IRA. Upon your death, the account transfers to your 75-year-old wife who is the named beneficiary. She does not need to take minimum withdrawals because she can treat the Roth account as if it were her own. She, too, does not take any withdrawals. She does, however, need to declare the account her own by renaming the account in her name and designating her son as beneficiary.

At the age of 92, she dies and passes the Roth to her son, the designated beneficiary when the wife assumed ownership of the account. The son, who is 62 years old, must make minimum withdrawals over the rest of his lifetime (which we'll assume – for purposes of discussion – is 25 years.) If he takes only the minimum required distribution he will preserve the account's tax-free earning capability. It is important that he began taking minimum distributions following his mother’s death, or he will be required to liquidate the account after five years. That would, of course, put an end to tax-free income associated with this conversion.

By converting at the age of 70, you maximized your estate planning with an account that continued earning tax free income for the rest of your life, your wife’s life and your son’s life. Quite an achievement when you consider you waited until you were 70 to make the conversion!