Estate Planning with Roth IRAs
An IRA, especially a Roth IRA, is valuable for more than your retirement planning. Your estate plan can be much better when a Roth IRA is shrewdly used.
Instead of looking at the front-end tax benefits and costs, take the long-term view. While converting a traditional IRA to a Roth can save estate taxes, the Roth IRA also can leave your heirs better off even when your estate won’t owe federal estate taxes.
An IRA, whether traditional or Roth, is included in the owner’s gross estate. After a traditional IRA is inherited, the beneficiary must include all distributions in gross income just as the original owner would have (which means Roth distributions are tax free). The beneficiary is able to stretch the distributions over his or her life expectancy, but annual distributions from an inherited traditional IRA are required and will be taxed.
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.
Suppose that instead of maintaining the traditional IRA for life you convert it to a Roth. 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.
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 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 gift. In the future when your beneficiary takes distributions from the Roth IRA, those distributions are tax free. In addition, you and your heirs avoid any taxes on future growth of the IRA.
Second, paying the taxes now reduces the size of your estate and any taxes on it. This is key for taxable estates and also is important when you live in a state with an estate or inheritance tax. Remember, the traditional IRA has an embedded income tax bill. Your beneficiary enjoys only 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 provides lifetime income tax benefits to you. 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 are, the higher the required distributions and the taxes on them will be.
RMDs and all the stealth taxes turn tax planning on its head. You and your beneficiary are likely to be better off when you pay the taxes early, such as in a conversion. After that, there are no RMDs, the IRA compounds tax free, and future distributions are 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.
Classic income tax planning says to defer taxes for as long as possible. But some things are different now. For some people, it pays to pay the taxes now by converting a traditional IRA to a Roth IRA, especially if you expect the IRA will be around for your heirs to inherit.