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Roth IRA Conversion Can Benefit Your Estate Plan

Estate Planning

By now, you’ve probably been inundated with media stories and ads touting the benefits of Roth IRA conversions, which are now open to everyone, regardless of income. Roth IRAs are known for their ability to deliver tax-free income during retirement. But a Roth may realize some of its most significant advantages after your retirement has ended. When the future of the estate tax finally gets resolved, converting a traditional IRA to a Roth will likely reduce any estate taxes your heirs may owe. And it will definitely cut their income tax bill on distributions from inherited IRAs.

Qualified distributions from a Roth IRA that has been established for at least five years are completely exempt from income tax. You’re eligible to receive this tax-free income once you reach age 59½, and qualified distributions are also possible in case of death or disability or to pay first-time homebuyer expenses (up to a lifetime limit of $10,000). Another plus is that with a Roth IRA, there’s no rule requiring distributions that must begin for holders of traditional IRAs after age 70½. So if you don’t need the money, investment gains in your account can continue to compound indefinitely without being eroded by taxes.

You will have to pay income tax on the portion of a Roth IRA conversion representing tax-deductible contributions and earnings, and it’s best to cover that liability with funds from outside your IRAs. But converting to a Roth is usually worth it for retirees looking to preserve a nest egg for their heirs.

Before 2010, you weren’t allowed to convert a traditional IRA to a Roth in a year in which your adjusted gross income (AGI) exceeded $100,000. But the Tax Increase Prevention and Reconciliation Act of 2005 eliminated this dollar cap for conversions after 2009. Also, if you convert your retirement account in 2010, you can spread the income from the conversion over two years and pay your resulting tax liability in 2011 and 2012.

When you convert to a Roth IRA, you’re effectively prepaying income tax for your heirs without using up the annual gift tax exclusion or your estate tax exemption. You can then use those valuable provisions to shelter other transfers from possible taxes. At the same time, you’re able to reduce the size of your taxable estate—by paying the tax due on the conversion—and that could provide further tax savings, depending on what happens to the federal estate tax.

Nonspouse beneficiaries who inherit a traditional IRA normally must empty the account—and pay income tax on the distributions—within five years or over their life expectancies. And though a Roth still requires heirs to make withdrawals spread out over their lifetimes, there will be no income tax for them to pay. That can result in substantial benefits even if a Roth account is established too late for its original owner to enjoy much of its bounty.

Consider the case of John, Jane, and their daughter, Mary. John converts his traditional IRA to a Roth in 2010 when he’s 65. He names Jane as the sole beneficiary of the Roth, and when he dies at age 73, she is 70. Based on IRS tables, Jane’s remaining life expectancy is 17 years. As a spouse, Jane can choose to treat the Roth IRA as her own and isn’t required to take distributions. She designates Mary as sole beneficiary, and when Jane passes away at age 87, Mary inherits the Roth IRA. She’s 55, and tax rules require her to take annual payments from the account that she could spread over her life expectancy of 30 years.

What has this accomplished? John lived for eight years after converting his traditional IRA to a Roth. Jane then had access to the account’s tax-free income for 17 years, and Mary had the account for another 30 years. That’s a total of 55 years for a Roth IRA established by 65-year-old John. Converting to a Roth creates a tax-free annuity for your heirs that should last well beyond your life expectancy.

To get these benefits, Roth IRA accounts must be properly titled and have the appropriate beneficiary designations. And after an account holder’s death, nonspouse beneficiaries must begin required (but tax-free) distributions from the account by December 31 of the following year. Miss that deadline and the account will have to be liquidated within five years.

Tax laws are never written in stone, and future changes could reduce the effectiveness of this technique for maximizing tax benefits for your heirs. But for now, at least, a Roth conversion provides substantial estate planning benefits. If you’d like to explore whether it would make sense to convert your traditional IRA, please call to set up an appointment.


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