You may already be aware that Congress is ready to give away the farm, at least as it relates to the Roth conversion. As a result, there has never been a better time to look at utilizing the Roth IRA as both a retirement and estate-planning tool. The Roth conversion process has become more streamlined recently. There are also fewer restrictions than in the past, thanks to the Tax Increase Prevention and Reconciliation Act of 2005.
Beginning in 2010, TIPRA will eliminate the $100,000 modified adjusted gross income (MAGI) limit that currently restricts those who can convert from a traditional IRA to a Roth IRA. Under TIPRA, income generated as a result of a Roth conversion can be reported ratably over years 2011 and 2012.
The Roth IRA is widely known as a tax-friendly vehicle for retirement. However, because we get caught up in the tax-friendly savings aspect of the Roth IRA, we tend to overlook the fact that it also offers a great way to effectively leave money to heirs while lowering one’s estate tax burden.
With the traditional IRA, individuals may receive a tax deduction for annual contributions, which allows the account to grow tax-deferred for an extended period of time. The drawback, of course, is that when retired individuals begin withdrawing money from the account, they must then pay taxes on any amounts withdrawn.
With the Roth IRA, investors do not receive a tax deduction on their contributions, so they are essentially making contributions with after-tax money. As such, the account will grow tax-free. Furthermore, as long as certain qualifiers are met, no taxes are due when an individual begins withdrawing funds at retirement because the taxes were already deducted when the contributions were made.
Perhaps even more important, the individual’s spouse and/or heirs will not have to pay taxes upon inheriting these funds. Standard inherited-IRA rules still apply, but as long as the 5-year holding period had been met by the decedent, the funds can be accessed free and clear.
What are the effects?
So why would it make sense for the holder of a traditional IRA to convert funds to a Roth IRA?
First, consider the surviving spouse. A Roth IRA has no required minimum distribution (RMD) requirement. If a surviving spouse inherits the Roth account, he or she need not take any minimum withdrawals. Conversely, with a traditional IRA, a surviving spouse who takes over the IRA must begin taking taxable withdrawals from the account no later than one year after reaching age 70 1/2 , thereby losing out on the chance to continue to compound the account without paying taxes. Thus, use of the Roth IRA allows for an easy transition from surviving spouse to secondary beneficiaries, such as children.
Another long-term effect of converting to a Roth IRA is the reduction of one’s taxable estate by the amount of income tax paid upon any conversion, which can greatly reduce the estate tax burden for heirs. Consider the following scenario:
Dan owns a traditional IRA worth $500,000, and he’s turning 70 1/2 this year. He already receives a decent pension and his primary intent is to leave these funds to his children. Dan also intends to convert this account to a Roth IRA.
IRS code requires that Dan take a taxable RMD of approximately 3.65% for 2008, which equates to about $18,250. As the RMD phase begins, he will begin depleting his qualified accounts and paying taxes on the distributions. This potentially leaves less money for Dan’s spouse or children to inherit.
Furthermore, because it’s considered part of his modified adjusted gross income (MAGI), the RMD can also affect taxation of his Social Security benefits. In addition, according to Publication 590, if Dan fails to convert before the year he turns 70 1/2 , he is required to take his initial RMD during that year and loses out on the potential tax-free growth of the portion he was forced to withdraw.
Risks and rules
For conversion-related retirement and estate planning strategies to be effective, several factors must be taken into consideration.