Estate Planning
Leave Your Kids a Tax-Free Legacy
Converting your traditional IRA to a Roth can be a boon for children and grandchildren.
By Susan B. Garland, Editor, Kiplinger's Retirement Report
January 1, 2010
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EDITOR'S NOTE: This article, originally published in the September 2009 issue of Kiplinger's Retirement Report, has been updated in January 2010. To subscribe, click here.
Let's say you have a traditional IRA, and you'd like to leave all or most of it to your kids or grandchildren. Consider converting the retirement plan to a Roth IRA.
Rolling a traditional IRA into a Roth IRA is treated as a taxable distribution, so you will pay income tax in the year you convert (in 2010 only, you can elect to defer and split the tax bill). The assets will continue to grow, and your offspring will be able to take tax-free distributions for the rest of their lives. "Once Dad pays tax on the seed, the harvest for the children and grandchildren is tax-free," says James Lange, author of Retire Secure!: Pay Taxes Later (Wiley, $25).
To show the potential of the Roth conversion strategy for estate-planning purposes, Lange offers this illustration. Two 65-year-old fathers in the 28% tax bracket have traditional IRAs, each containing $100,000. Each parent also has $28,000 in a taxable account.
One father converts his traditional IRA to a Roth IRA, using his $28,000 to pay the tax. The other father doesn't convert. The Roth parent doesn't have to take required minimum distributions, and he lets the entire account grow tax-free. The traditional father must take RMDs starting at age 70 1/2. They both live 20 years and leave their IRAs to their children, who are the same age.
After the parents die, each child must take RMDs. Thirty years after the parents' deaths, the Roth child has $1.8 million in future dollars, assuming an 8% annual rate of return. Meanwhile, the traditional child has only $980,800. Why the difference? The traditional parent and child paid taxes on an RMD every year for 50 years. Meanwhile, the Roth parent took no distributions, and the Roth child took annual RMDs tax-free.
A conversion could also eliminate or lower federal and state estate taxes, says Natalie Choate, estate-planning lawyer at Nutter McClennen & Fish, in Boston. Say you're in the 33% tax bracket and your $4 million estate includes a $2 million IRA. If you convert the IRA, paying about $650,000 in federal income taxes will drop your estate below the $3.5 million federal estate-tax exemption (assuming Congress retroactively reinstates it).
Robert Miller, 80, who lives in Penn Hills, Pa., has made a series of conversions to a Roth IRA over the years. Miller, a retired engineer, converted another chunk in 2009. Rather than selling investments in his traditional IRA and moving the cash to the Roth, Miller planned to simply transfer shares of stock from one IRA to the other. Because the market value was depressed, Miller could transfer a larger number of shares. As the market rebounds, those shares will appreciate in the Roth IRA tax-free—a boon to his three children. "Taxes will go up, so this is one way to ease the burden for them," he says.
Heirs Must Follow Rules
If you want your heirs to stretch this tax-free shelter over their lifetimes, talk with them now about the rules they must follow after you die. Although a widow or widower can roll an inherited IRA into his or her own Roth, other beneficiaries cannot.
Instead, a non-spouse heir must set up an "inherited IRA," and the name of the deceased must remain on the account. Lange suggests language something like: "Inherited IRA of Joe Sr. for the benefit of Joe Jr." The money must be transferred directly into the new IRA.
If you have several beneficiaries, they should split the account into separate inherited IRAs. If they don’t split the IRA by December 31 of the year after your death, their RMDs will be based on the life expectancy of the oldest beneficiary -- yielding larger distributions and depleting the account more rapidly. By splitting, heirs can each use his or her own life expectancy.
A couple of cautions: It’s best to pay the income tax on the conversion with non-IRA money so you preserve the account's growth potential. And it may not make sense to convert if you're in a high tax bracket and your kids are in a lower one.
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Reader Comments (6)
Posted by: Mike at 11/04/2009 11:19:57 AM
It does not account for the possibility of estate taxes that are due and the need to perhaps cash it in for estate taxes. Remember, the estate tax exemption reverts to $1,000,000 in 2011 unless Congress does something to extend it or enlarge it -- a curious possibility in light of the hugh deficits.
Posted by: Primary Al at 11/06/2009 04:00:39 PM
ROTH is good for younger ones in low brackets. For older folks in high brackets the markets volatility makes for almost incalculable contingencies. What do we think the motive is for governments' encouraging taxation NOW on IRA /401K accounts? Is it for us or them? Could it be that a future flat tax is inevitable? The deferred IRA/401k would automatically become ROTH status in a flat tax scenario due to the fact that it would be unfair to tax money coming out of a tax deferred IRA only to be hit again with a flat tax on any goods purchased. Furthermore, let us remember; When one sends tax money off the the government, that is the last time that money will ever earn interest again.
Posted by: Primary Al at 11/06/2009 04:27:45 PM
Converting to a ROTH at retirement in a high tax bracket is just what the government wants. They want the tax revenue now. Making such an expensive move based on the belief that the stock market will behave in a manner differently than it has over the past ten years is as high risk an assumption as it is today to trust a stock market mutual fund with your money unmonitored. PS There's a reason a certain Mr. Lynch no longer manages such cumbersome portfolios. It is because he has found that it is almost impossible for money managers to beat the market in the long run.
Posted by: Primary Al at 11/06/2009 04:32:43 PM
It is unlikely that this mag will post anything unfavorable to mutual funds, and the prospects of a projected long term stock market performance dramatically dissimilar to the phenomenon of the 70s 80s and 90s.
Posted by: Primary Al at 11/06/2009 05:11:29 PM
Roth conversion is a high tax bracket for estate planning?? Why risk losing 30-40% of a currently intact principal to avoid taxation on a portfolio that might be dramatically lower in value in ten or fifteen years? @age 65 a man in good health would be doing his family a very manageable almost risk less favor by instead-systematically gifting non tax deferred monies to an irrevocable trust. These funds would subsequently be used for funding a low cost universal life insurance contract outside of the taxable estate, calculated for the immediate, tax free, probate free-payment/settlement of any estate income tax and estate inheritance tax. The guaranteed benefit would be a risk-less leveraged asset, free of creditors, and expensive administration, available to settle taxation on the 401K/IRA, and if the benefit were sufficiently large it would actually add quick liquidity for other financial contingencies, which would shorten the estate settlement process-lessening attorney fees. This kind of planning, it goes without saying must be done while one or more of the estate owners are in reasonable good health with no serious health history directly related to a decreased life span. If a policy can be issued favorably, the asset transfer process to the trust would also help reduce the size of the taxable estate while leveraging the money flowing to the trust upon death. If the prospects of losing investment potential on the gifted money is a concern, the life policy could be of a variable nature, which allows the values building in the life policy to reside in selected mutual fund sub accounts chosen by the trust administrator.
Posted by: Hold on a second at 12/30/2009 11:03:03 PM
It seems that in the Roth vs. Traditional example, the calculation ignores the fact that the Traditional IRA would also presumably be inherited with the $28,000 savings account that Traditional father did not have to spend in taxes to convert it. This changes the numbers significantly.