Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Roth IRAs Are Compelling Estate Planning Tools

Last update on: Nov 25 2019

Roth IRAs can be powerful additions to your estate plan, regardless of your age. Most people focus only on lifetime income taxes when discussing roth iras. Roth IRAs can be powerful tools that help meet your Estate Planning goals, leaving your heirs with more after-tax wealth.

An IRA will be included in your estate whether it is a traditional or Roth IRA. That doesn’t matter to most people these days, because their estate won’t face federal estate taxes. But it can matter if you live in a state with an estate or inheritance tax. It also will matter to more people if the current estate tax exemption amount expires after 2024 as scheduled and reverts back to the previous level.

The only way to keep an IRA from being included in your estate is to empty it, pay the income taxes and transfer the after-tax amount outside of your estate. The real issue for most of us is how the IRA distributions will be taxed, especially to our heirs.

A beneficiary who inherits a traditional IRA must take required minimum distributions (RMDs) from the inherited IRA. Those distributions will be taxed the same way they would be for you. Most IRA distributions will be fully taxed as ordinary income. The beneficiary can take the distributions over his or her Life Expectancy or until the money is needed, taking advantage of the tax-deferred compounding of the IRA. But the beneficiary inherits only the after-tax value of the IRA, not the full value.

Also, consider the income taxes during your lifetime. After age 70½, you must take RMDs from a traditional IRA, whether you need the money or not. As we’ve discussed in the past, RMDs often cause income tax problems for IRA owners. The RMDs generate taxable income. They also increase adjusted gross income (AGI).

Higher AGI can mean more of your Social Security benefits are taxed and you might owe the Medicare premium surtax. An alternative as part of your estate plan is to convert a traditional IRA or 401(k) to a Roth account. Of course, there is an income tax bill for converting the account.

The amount you convert is included in gross income as ordinary income and taxed at your regular tax rate. In effect, you’re paying the taxes early instead of waiting for the IRA to be distributed over the years. Once that is done, there will be several long-term benefits.

First, you’re in effect paying income 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 there are no estate or gift taxes on that gift. In addition, you and your heirs avoid any taxes on future income and gains earned by 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 traditional IRA. But federal and state death taxes will be imposed on the market value. The estate taxes would be paid on the embedded income taxes.

Third, the conversion provides lifetime income tax benefits to you. When you don’t need the RMDs after age 70½ to meet expenses, they simply increase your taxes. The older you are, the higher the percentage of the IRA that must be distributed each year. RMDs and all the taxes they trigger 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 for you, and the IRA compounds tax free.

There are several factors to consider before deciding that converting an IRA to a Roth IRA should be part of your estate plan.

  • Compare current and expected future tax rates for you and your beneficiaries. A conversion makes the most sense when future income tax rates are expected to be higher. But it also can make sense when you expect tax rates to be the same, especially if distributions will be spread over 12 years or more.
  • A conversion makes less sense when you anticipate the IRA beneficiaries are likely to be in a lower tax bracket than you. Then, it often is best to leave the traditional IRA intact and let beneficiaries pay income taxes on distributions over the years at their lower rate. But that also assumes you won’t be forced to draw down most of the IRA during your lifetime through RMDs.
  • This strategy also shouldn’t be used if you’re likely to need most of the IRA balance during your lifetime. It’s best used by the many people who are reserving their IRAs for emergencies or as something to leave their heirs. The longer you can leave the IRA to compound after the conversion, the more a conversion pays off.
  • Consider the amount of charitable giving you plan during your lifetime and through your estate. It makes a lot of sense to make charitable gifts through a traditional IRA. During your lifetime, you can make qualified charitable distributions. Through your estate, you can name one or more charities as beneficiaries of your traditional IRA. To the extent you make charitable gifts, it is better to make these through your IRA than to leave the IRA to your loved ones. Leave your loved one’s other assets, if you can.
  • An IRA conversion is not an all-or-nothing event. You can convert part of your IRA when that makes sense. For example, you can retain enough in your traditional IRA to make planned charitable gifts and to have available as a cushion for your retirement expenses.

The rest you can convert to a Roth IRA to leave to your heirs. Or if you don’t want to pay the taxes to convert the entire IRA, you can convert only part of it or convert a portion each year for a period of years. There’s still a myth circulating that Roth IRAs are only for relatively young people. In fact, they can be powerful estate planning tools that provide benefits to you and your heirs for decades.

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