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The Descendent Wealth IRA: The Key To Tax Minimization

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Having worked hard and planned well, an IRA owner may find that the accumulated funds of the IRA are not needed for retirement. The IRA likely has considerable value, however, and since a traditional IRA is subject to both estate and income taxes, over half of its value may be depleted by the time the beneficiaries receive any benefit.

The Roth IRA advantage

A Roth IRA has several important advantages over a traditional IRA. A Roth IRA is not subject to required minimum distributions (RMDs), income tax upon distribution, or income in respect of a decedent (IRD) upon receipt by beneficiaries after the IRA owner’s death.

When converting a traditional IRA to a Roth, income tax must be paid on the IRA assets. By using life insurance to fund the income tax that must be paid upon the conversion, the full value of the IRA can be preserved. To maximize the value of a Roth IRA to the named beneficiaries upon the owner’s death, an additional insurance policy may be obtained to pay for the estate tax that will be attributable to the Roth IRA upon the owner’s death.

The following is a strategy to help maximize the value of the IRA when the spouse is the IRA beneficiary named on the traditional IRA.

Maximizing the IRA’s value for the beneficiaries

Consider preparing for the future by converting a traditional IRA to a Roth IRA upon the IRA owner’s death. Anytime after the IRA owner reaches the age of 59 1/2 , when there is no penalty for the withdrawal of funds from the IRA, he/she withdraws an amount sufficient to purchase a life insurance policy.

Because a Roth conversion is subject to income taxation, this solution provides a source of liquidity to pay the taxes. At the IRA owner’s death, the traditional IRA is passed to the spouse (without estate taxes under the unlimited marital deduction). The spouse converts the traditional IRA to a Roth IRA, (provided he/she meets the $100,000 income cap for Roth conversions, which no longer applies after 2009). The major benefits of the Roth IRA are that there are no distribution requirements and any distributions taken are income tax-free.

The spouse, who does not need the amounts held in the Roth IRA, allows the Roth to grow, to be distributed to beneficiaries upon his/her death. To keep the Roth IRA intact at the second spouse’s death, a second insurance policy, funded from RMD (or other sources), could be used to pay the estate tax attributable to the Roth IRA. Not only will the children receive the Roth IRA income and estate tax-free, they may elect to stretch the Roth payments over their lifetimes, taking further advantage of the tax-free growth and distributions afforded a Roth.

Results and examples

Today, a husband and wife are both 71 years old. His IRA is valued at $3 million and growing at 6% per year. After taking into account his annual RMDs, the balance of his IRA in 15 years (his life expectancy) would be $3,455,000. If his wife survives him by 5 years, the net amount left to their heirs would be approximately $1,426,000 after estate and income tax are paid out of the Roth funds.

Due to his age, the husband is required to take RMDs from his IRA. He will use a portion of this annual distribution to pay the premium on a $1.2 million life insurance policy. At his death, the IRA will pass to the spouse without estate tax using the unlimited marital deduction, and she will convert it to a Roth IRA (assuming she meets the income limits, which no longer apply after 2009).

The wife uses the $1.2 million life insurance policy proceeds to pay the income tax due on the Roth conversion (approximately $1,209,000, assuming a 35% tax bracket), thereby allowing the full $3,455,000 IRA to be converted to a Roth IRA. When the spouse passes away 5 years later, the Roth IRA will be worth $4.6 million.

Anticipating that the Roth IRA will be subject to estate tax, the couple purchases a survivorship life insurance policy using an additional portion of the husband’s net RMD, which will be used to pay the estate tax attributable to the Roth IRA. After the conversion and the payment of the estate tax with the proceeds of the survivorship policy, subsequent distributions from the Roth IRA to the children will be estate and income tax free.

Using this strategy, the children will inherit more than three times more than they would without planning.

Janice A. Forgays, Esq., CLU, is vice president, advanced markets for the U.S. Division of Sun Life Financial in Wellesley Hills, Mass. She can be reached at [email protected]


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