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Roth IRAs: A Strategic Tool in Estate Planning

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As life expectancy increases and baby boomers retire in record numbers, more middle-class Americans are creating or revising wills and living trusts to leave as much as possible to their loved ones. As an advisor, you can provide one more compelling reason for new and existing clients to rely on you and your financial guidance, by demonstrating the potential benefits of converting traditional Individual Retirement Accounts (IRAs) into Roth IRAs when discussing estate planning strategies.

Many IRA owners and retirement plan participants seeking your advice already know about the benefits of the Roth IRA when saving for retirement. But they might not realize the Roth IRA is equally effective as an estate planning tool.

Individuals who convert a traditional IRA into a Roth IRA can reduce their estate taxes. They can also eliminate the income tax their heirs would otherwise have to pay on withdrawals taken from an inherited traditional IRA.

Planning Ahead to 2010

Until recently, the Roth IRA, an excellent tax-advantaged investing tool, had been unavailable to higher- income taxpayers. Now you can remind these individuals to take advantage of special provisions in the current tax law that will take effect in 2010. These provisions eliminate the existing $100,000 maximum income criteria and allow anyone regardless of income to convert a traditional IRA to a Roth IRA. This is particularly important because the current federal estate tax laws are scheduled to sunset in 2010.

With your estate planning guidance, individuals can take advantage of the 2010 conversion rule. In that year only, an individual has the option of paying the income tax resulting from the conversion divided equally between 2011 and 2012 as opposed to paying all of the tax at once.

It is even conceivable that your clients could want to make nondeductible contributions to their traditional IRAs in 2008 and 2009 and get a jump start on the new law. The entire amount built up prior to 2010 will be available for conversion in that year.

Easing into Conversion

When creating their estate plans, many people will wonder what implications this tax law change will have. If your clients continue with their traditional IRA, they will need to begin taxable minimum distributions from their account by April 1st of the year following the year they turn 70 1/2 years old, whether they need the money or not. This reduces the positive effect of tax deferred compounding interest.

In the past, your clients who were over 70 1/2 , and receiving minimum distributions from their traditional IRAs, may have had their incomes pushed above $100,000 and would not qualify for the traditional conversion. The 2010 law will change this.

By converting to a Roth IRA, your clients can avoid the required minimum distributions and let their future savings grow income-tax-free. They do have to pay tax on any accumulated earnings or tax-deductible contributions. Your clients choosing a Roth IRA not only will reduce the size of their estate and their resulting estate tax liability, but their heirs will inherit a tax-free income stream.

For this strategy to make the most financial sense, clients need to understand that when they make the conversion, they should pay the tax out of their non-IRA assets. By paying the conversion tax, they are effectively prepaying the income tax for their heirs without owing any gift tax or using up their valuable $2 million estate-tax exemption for 2006-2008. Additionally, prepaying the income taxes reduces the size of their taxable estate.

This strategy can also be used with clients who do not plan to use the money in the Roth IRA during their lifetime. These clients are paying the high upfront conversion fees for the Roth IRA because they intend for their heirs to have years of tax-free income.

Spouses who inherit a Roth IRA can forgo taking any withdrawals, achieving the maximum tax-free growth for their money. Even if one spouse has inherited a traditional IRA from the other spouse, it is still not too late to discuss converting to a Roth IRA as part of the surviving spouse’s estate plan.

Although traditional IRAs can offer current tax deductions and tax-deferred growth, withdrawals are subject to ordinary income taxes. A Roth IRA takes the opposite approach for your clients, because contributions aren’t deductible. Qualified withdrawals of contributions and–best of all– earnings are income-tax-free. The Roth IRA is definitely superior from an estate planning perspective.

In Summary

Roth IRAs provide clear estate planning benefits for your clients. Not only are distributions to their heirs income-tax-free, but the amounts they pay in taxes on the income they contribute to the Roth IRA are removed from their estate. In other words, by paying taxes associated with a Roth IRA, your clients essentially have the opportunity to make a tax-free gift to their heirs.

It is always important for your clients to understand that a Roth IRA is not the complete answer to their estate planning needs. But, by offering clients a coordinated approach to estate planning that includes a will, a trust, and a Roth IRA conversion strategy, you can increase the assets retained by the family and build your value as their trusted advisor.

Herb White, CLU, ChFC, CFP, MBA is president of Life Certain Wealth Strategies. He founded the company in 2003 as an independent, unbiased financial planning firm focused entirely on providing comprehensive solutions for clients’ financial challenges. Mr. White is a frequent speaker at financial planning seminars and workshops sponsored by employers and other organizations in the Denver area. He also writes frequent guest columns for the Denver Business Journal.


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