How to use a Roth IRA as part of your estate plan

Seniors who convert a regular IRA into a Roth account can reduce their estate taxes.

  • By Bill Bischoff,
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When it comes to saving for retirement, many investors already know how well the Roth IRA fends off Uncle Sam. But what they may not realize is that it’s equally effective as an estate-planning tool.

Seniors who convert a regular IRA into a Roth account can reduce their estate taxes and eliminate the income tax their heirs would otherwise have to pay on withdrawals taken from an inherited regular IRA. Sound too good to be true? Well, it is true. Here’s how it works.

No annual required minimum withdrawals

The first benefit comes from the fact that Roth accounts are not subject to the annual required minimum-withdrawal rules that apply to regular IRAs. These rules force you to begin draining your regular IRA after you turn 70½. Of course Uncle Sam is there for his handout, and your friendly state-tax collector is next in line. This is galling when you would prefer to continue deferring taxes by leaving your IRA balances untouched.

Converting your regular IRA into a Roth puts a halt to this required minimum withdrawal nonsense. After the conversion, you can live out the rest of your days without being forced to take any Roth withdrawals.

You are free to leave the Roth account balance untouched and accumulate as many tax-free dollars as you can for your estate. (If you convert after age 70½, you still have to take one final minimum withdrawal for the conversion year; whatever is left in the regular IRA can then be converted to Roth status.)

Paying the tax

Of course, you will have to pay federal income tax (and maybe state income tax too) on any accumulated earnings and tax-deductible contributions when you make the Roth conversion. That is because the conversion is treated as a taxable withdrawal from your traditional IRA followed by a nondeductible contribution to a Roth IRA. The tax hit isn’t such a bad thing, as long as you can afford to pay the tax out of non-IRA assets.

By paying the conversion tax bill, you are effectively prepaying income tax for your heirs without owing any gift tax or using up any of your valuable unified federal gift and estate tax exemption ($11.4 million for 2019). Plus, the income tax prepayment reduces your taxable estate, which is also a good thing.

After you die

After you die, your Roth IRA balances become subject to a special set of requirement minimum withdrawal rules that apply to inherited IRAs. So your heirs will have to start taking mandatory annual withdrawals. Those withdrawals will be federal-income-tax-free as long at least one of your Roth accounts has been open for more than five years as of the withdrawal dates. And if your heirs can afford to leave their inherited Roth-account money untouched — except for the required minimum withdrawals — they can string out those withdrawals over their life expectancies (usually many years) and thereby continue to earn tax-free income on the remaining Roth account balance.

Example: Hubby is 65. He converts his regular IRA into a Roth account and lives for eight more years, gloating all the while about the tax-free status of the account and never taking out a dime. After his death, the Roth IRA goes to Wife, the named beneficiary, who is age 70 at the time. According to IRS life-expectancy tables, Wife should live another 17 years. Since she can treat the inherited Roth account as her own, she need not take any required minimum withdrawals as long as she is alive. Being thrifty, she doesn’t take out a dime. As scheduled, she passes the Roth baton at age 87 to Daughter, who was designated as the new beneficiary when Wife took over the Roth account.

Daughter is 55. The IRS says her life expectancy is 30 years. Now the endgame has been reached. She must start taking required minimum withdrawals over 30 years. But she takes only the minimum each year, thus preserving the account’s tax-free earning power for as long as possible. In this example, the Roth account “lives” eight years with Hubby, 17 years with Wife and 30 years with Daughter. That’s 55 years in all. Not bad, considering Hubby was a well-seasoned 65 years old when he did his Roth conversion deal.

What really happened here is that Hubby and Wife used the Roth IRA to set up a long-term tax-free annuity for Daughter. Of course, for all this to work out as illustrated, Hubby should designate Wife to be the beneficiary of the Roth IRA upon his death. At that point, Wife should declare the Roth account her own by retitling the account in her name and designating Daughter as the account beneficiary upon Wife’s death.

Finally, Daughter must begin taking annual required minimum withdrawals by Dec. 31 of the year following her mother’s death. Otherwise, Daughter will have to liquidate the account after five years, which would bring a premature end to all the fun associated with tax-free Roth IRA income.

Risks

For this strategy to make sense, two things must happen. First, the tax rules for Roth IRAs must remain the same as they are now. Second, you must believe you won’t need the money in the Roth IRA during your lifetime and that your heirs will pretty much leave the account alone, except when required to take minimum withdrawals to comply with the tax guidelines.

To the extent these assumptions prove untrue, the idea of using a Roth IRA to create a tax-free annuity for your heirs becomes that much less attractive. Remember, you are paying a relatively high price — the upfront conversion tax hit — in order to set your heirs up for future tax savings that you hope will extend over many years.

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