Roth IRAs as Estate Planning Tools

Many people focus on the retirement and income tax aspects of Roth IRAs. Not enough people consider the estate planning benefits they could reap by converting a traditional IRA (or a 401(k) plan) into a Roth IRA. Your loved ones could receive more after-tax wealth from the Roth IRA, whether or not your estate is subject to federal estate taxes. An estate that is likely to face federal estate taxes could benefit even more than others from converting a traditional IRA to a Roth IRA.

A conversion as an estate planning tool should be considered primarily when the estate owner’s standard of living seems secure without the IRA. The IRA is thought of as an emergency fund and something being maintained to pass to heirs. The goal, then, is to try to ensure the maximum after-tax wealth for heirs.

An IRA, whether a traditional or a Roth, is included in the owner’s gross estate. You can’t avoid that. But when a traditional IRA is inherited, the beneficiary must include all distributions in gross income just as the original owner would have. The distributions are taxed at the beneficiary’s ordinary income tax rate. The beneficiary is able to stretch out the distributions over his or her life expectancy, but annual distributions are required and will be taxed.

The income taxes are in addition to any federal estate taxes (and don’t forget state income, inheritance, or estate taxes). An IRA avoids probate.

Distributions from an inherited IRA are known as income in respect of a decedent, which could give the beneficiary a tax deduction for the share of estate taxes attributable to the IRA. The deduction shelters a portion of the IRA distributions from taxes. See IRS Publication 559 for details about the write off.

After both income and estate taxes, the beneficiary is able to spend less than 100% of the traditional IRA. How much less than 100% depends on the estate tax and income tax rates. Often the after-tax value of an IRA is two-thirds or less of the original value.

Suppose you convert a traditional IRA to a Roth IRA. In a conversion, you treat the converted amount as though it were taken as a distribution. So, you pay income taxes on the converted amount.

The first estate tax benefit of the conversion is your estate is reduced by the income taxes you pay on the conversion. Most people don’t want to pay taxes before they have to, but this tax bill has several long-term benefits.

First, you’re in effect paying the taxes for your heirs. They would have owed the taxes in the future when taking distributions from the IRA. Instead, you pay them now, and avoid estate and gift taxes on that amount. When your beneficiary takes distributions from the Roth IRA, those distributions are tax free.

Second, paying the taxes now reduces the size of your estate and any estate tax bill. This isn’t a factor for estates below the taxable level, but it is key for taxable estates. Remember, the traditional IRA has an embedded income tax bill. Your beneficiary benefits only from the after-tax amount, not the market value of the IRA. But federal and state death taxes will be imposed on the market value. So your estate would be paying estate taxes on the embedded income taxes.

Third, the conversion can provide lifetime income tax benefits to you that also can benefit your beneficiary. When you maintain a traditional IRA, after age 70½ you’re required to take minimum annual distributions. When you don’t need this money for spending, it simply increases your taxes. It could increase your income enough to push you into a higher tax bracket, reduce itemized deductions, increase taxes on Social Security benefits, and have other effects. The older you become, the higher the required distributions and taxes become. You and your beneficiary are likely to be better off when you pay the taxes one time in a conversion and let the IRA compound tax free.

The benefits of paying income taxes now instead of later are reduced when you are in a higher tax bracket than your beneficiary is likely to be when he or she takes distributions from the inherited IRA. But that doesn’t eliminate the benefits of conversion, and it’s difficult to forecast the tax bracket your beneficiary will be in over the rest of his or her life.

Another potential estate planning benefit of converting the traditional IRA to a Roth IRA is the beneficiary can create a Stretch Roth IRA.

Unlike the original owner, a beneficiary of a Roth IRA is required to take minimum distributions over his or her life expectancy. When the beneficiary is relatively young, there is the potential for the distributions to be less than the annual earnings of the IRA, so the IRA grows while the distributions are being taken. Of course, the beneficiary can take more than the minimum, even the entire Roth IRA, at any time tax free. But a beneficiary who wisely lets the Roth IRA compound will have it available to help fund his or her retirement.

There are several variables in the equation, but for a number of people converting a traditional IRA to a Roth IRA provides estate planning benefits. You can read more in my books The New Rules of Retirement and Personal Finance for Seniors for Dummies. Then, discuss the potential with your estate planner.