Estate Planning Tip: Utilizing a Roth IRA to Stretch Out Tax Benefits
A Roth IRA offers distinctive retirement-savings benefits since under current law, investments in this type of account can grow tax-deferred and withdrawals are tax-free. It also gives you the ability to avoid early distribution penalties on some withdrawals.
If you have a significant balance in your IRA and don’t plan to tap that balance during your lifetime, you may want to consider converting your IRA to a Roth IRA since it can benefit your estate. How? Well, the contributions made to a Roth IRA have the potential to grow larger than it otherwise might under traditional distribution rules, which means you’re leaving more for your loved ones. Another major benefit is that your beneficiaries can make income-tax-free withdrawals during their lifetimes.
There are some benefits to this IRA strategy, but it is not fail safe. A potential drawback to a Roth IRA is that the ability to contribute to this type of account phases out, based on your income. For example, if you are married and filed your taxes jointly, the contribution eligibility for a Roth IRA phases out between $178,000 and $188,000 of Modified Adjusted Gross Income, according to Schwab.com. But the good thing is that there is no limit, based on your Modified Adjusted Gross Income for converting a traditional IRA to a Roth IRA. Also, new rules recently went into effect that expand the eligibility to make a conversion from a traditional 401(k) account to a Roth 401(k) account, if your employer offers both.
A major drawback to this estate planning strategy is on the horizon. There was a recent proposal by the Obama Administration that would require “inherited IRAs” to pay out over five years rather than permit beneficiaries to stretch the distributions over their lifetime. This change would be dramatic. Traditionally, a big benefit to a Roth IRA, from an estate planner’s perspective, is that we can plan for grandchildren or similarly situated beneficiaries and stretch out the distributions for their lifetimes (for example, if the beneficiary is 10 years old now the money could build up significantly). This strategy could provide a nice nest egg if the grandchild does not have to pay taxes on any of the accumulation and distributions come out tax free 50 years from now. However, if the five-year-payout proposal is actually enacted and they close this out to five years that would be a big change.
Another issue to keep in mind about this Roth IRA estate planning strategy, if you convert your IRA to a Roth IRA, you will be required to pay the income tax in the year you convert. However, the income tax you pay on converting from a traditional IRA to a Roth IRA will reduce your gross estate. This means you are essentially prepaying income tax on behalf of your beneficiaries without it actually counting as a taxable gift.
So what’s the take-away? Speak to your financial advisor and an experienced estate planning attorney to determine whether or not transferring some assets to a Roth IRA is a sound strategy.