A Roth IRA is potentially a very powerful wealth transfer planning product. This is due to the deferred tax liability upon conversion and the absence of a required minimum distribution (RMD) requirement, which forces tax-favored funds to be distributed.
The deferred tax liability benefit results from enactment of the Pension Protection Act of 2006, which provides that any traditional IRA converted in 2010 will create a tax liability payable over 2 years, in 2011 and 2012.
The benefit of this delayed payment is that the funds can remain invested until needed to pay the income tax, thereby increasing after-tax return. The caveats: The benefit is temporary and limited to those taking action to convert in 2010.
Still, the absence of an RMD requirement is inherent in the Roth IRA rules. As demonstrated below, this absence is a most significant benefit for retirement and tax planning purposes. (Note: This does not apply to Roth 401(k) or 403(b) rules.)
Consider a hypothetical example for John Smith, who has a traditional $250,000 IRA and will attain age 70 1/2 in 2013. He will be required to start taking his RMDs in 2013. Let’s assume that Mr. Smith has a daughter Jane and that when he dies at age 85 in 2028, she will stretch her payments under the IRA for the maximum amount of time permitted by law. Finally, let’s assume that all investments earn 7% and that the tax rate applicable at all times is 35%.
Now, let’s compare the after-tax income distributed to Smith and his daughter Jane if he retains his IRA or, alternatively, if he converts the IRA to a Roth IRA in 2010. (Under the conversion approach, assume that Smith does not have other funds available to pay the tax liability associated with the conversion and so uses his IRA funds to pay the tax liability due in 2011 and 2012.)
The results of the 2 alternatives are striking and show just how much additional after-tax benefit the Roth offers.
In the case of the traditional IRA, the $250,000 IRA will provide $3,567,155 in after-tax funds for Smith and Jane by time the funds have been completely distributed to her in 2061.
However, by converting the IRA to a Roth IRA, the $250,000 IRA will provide $4,739,129 in after-tax funds for Smith and Jane by the time the funds have been completely distributed to Jane in 2061.
So, the Roth IRA will provide $1,171,974 of additional after-tax benefit, or around 33% more in after-tax dollars, when compared to the traditional IRA.
A small part of the almost $1.2 million in additional after-tax benefit is attributable to the fact that Smith incurs a tax liability upon conversion in 2010 but does not have to actually pay the tax liability until 2011 and 2012. The vast majority of the benefit, though, is due to the fact that there are no RMDs for the Roth IRA and the funds continue to enjoy tax-favored treatment until Smith’s death.
Having demonstrated the significant after-tax advantage of the Roth when rates are constant, and given the fact that tax rates are at historic lows, let’s next examine how the 2 approaches would compare if tax rates were to increase to 45% after Smith retires in 2013.
In this case, the $250,000 traditional IRA will provide $2,632,648 in after-tax funds for Smith and Jane by the time the funds have been completely distributed to Jane in 2061. However, by converting the IRA to a Roth IRA, the $250,000 IRA will provide $4,363,718 in after-tax funds for Smith and Jane by the time the funds have been completely distributed to Jane in 2061.
So, in this second example, the Roth IRA will provide $1,731,070 of additional after-tax benefit, or around 66% more in after-tax dollars, when compared to the traditional IRA. Again, a small part of the more than $1.7 million in additional after-tax benefit is attributable to the deferred tax liability upon conversion, and most is due to the absence of the RMD requirement. (See Table 1.)
The above examples assume that the taxes owed upon conversion to a Roth IRA would be paid from the traditional IRA, so no out-of-pocket expense was incurred.
What if Smith has an outside investment equal to the tax liability associated with the conversion to a Roth IRA, and he chooses to use those outside funds to pay the tax liability? He could effectively maximize what he can save in the tax-favored Roth product.
Let’s assume the tax rates applicable to the Smiths is 35% before and after Smith’s retirement. In this case, the traditional IRA and the outside funds provide $4,652,203 of after-tax funds for Smith and Jane. Alternatively, if the outside funds are used to pay the conversion tax liability, the Roth IRA provides $7,094,772 of after-tax funds for the Smiths, or $2,442,569 more.
This more than 52% increase, afforded by the Roth, shows how powerful it can be to maximize assets in the Roth if the customer has other funds with which to pay the conversion tax liability.
And what if tax rates go up to 45% when Smith retires? In that case, the traditional IRA and the outside funds provide $3,415,259 of after-tax funds for Smith and Jane. Alternatively, the Roth IRA and outside funds provide $6,532,757 of after-tax funds for the Smiths, or $3,117,498 more.
This is more than a 91% increase. It shows how the confluence of higher income tax rates and the ability to pay the conversion tax from other funds can geometrically improve the after-tax results from a wealth transfer perspective. (See Table 2.)
These examples help demonstrate why legislative changes over the years have made Roth products a powerful retirement planning vehicle, and why a Roth IRA can and should be considered for purposes of wealth transfer planning.