When it comes to saving for retirement, many investors already know how well the Roth IRA fends off Uncle Sam. But what they may not realize is that it's equally effective as an estate-planning tool. Seniors who convert a regular IRA into a Roth account can reduce their estate taxes and eliminate the income tax their heirs would otherwise have to pay on withdrawals taken from an inherited regular IRA. Sound too good to be true? Here's how it works.
No Minimum Withdrawals
The first benefit comes from the fact that Roth accounts are not subject to the minimum-withdrawal rules that apply to regular IRAs. These rules force you to begin draining your regular IRA the year after you turn 70 1/2. Of course Uncle Sam is there for his handout, and your friendly state-tax collector is next in line. This is galling when you don't need the money.
Converting your regular IRA into a Roth puts a halt to this nonsense. After the conversion (which is only available to singles or joint filers with adjusted gross incomes below $100,000), you can live out the rest of your days without being forced to accept withdrawal checks against your will. You are free to leave the Roth account balance untouched and accumulate as many tax-free dollars as you can for your estate. (If you convert after age 70 1/2, you still have to take one final minimum withdrawal for the conversion year; whatever is left in the regular IRA can then be converted to Roth status.)
Paying the Tax
Of course, you will have to pay tax on any accumulated earnings and tax-deductible contributions when you make the Roth conversion. But this isn't a bad thing, as long as you can pay the tax out of non-IRA assets. Why? When you pay the conversion tax, you effectively prepay income taxes for your heirs without owing any gift tax or using up any of your valuable estate-tax exemption of $1.5 million for 2004 and 2005. Plus, prepaying the income taxes reduces the size of your taxable estate -- also a good thing.
After You Die
Your heirs won't owe any income tax on withdrawals from the inherited Roth account. However, the account now falls under the same minimum-withdrawal rules as regular IRAs (see "Inheriting an IRA"). Nevertheless, if your heirs don't need the Roth-account money right away, they can string out those withdrawals over many years while continuing to earn tax-free income on the remaining account balance.
Husband is 65 this year. He converts his regular IRA into a Roth account and lives for eight years, gloating all the while about the tax-free status of the account and never taking out a dime. After his death, his Roth IRA goes to the wife, the named beneficiary, who is age 70 at the time. According to IRS life-expectancy tables, the wife should live another 17 years. Since she can treat the inherited Roth account as her own, she need not take any minimum withdrawals. Being thrifty, she doesn't take out a dime. As scheduled, she passes the Roth baton at age 87 to her daughter, who was designated as the beneficiary when the wife took over the account.
Daughter is age 55. The IRS says her life expectancy is 30 years. Now the endgame has been reached. She must start taking minimum withdrawals over 30 years. But she takes only the minimum, thus preserving the account's tax-free earning power as long as possible. In this case, the account "lives" eight years with the husband, 17 years with the wife and 30 years with the daughter. That's 55 years in all. Not bad, considering the husband was 65 when he did his conversion deal.
What really happened here is that the husband and wife used the Roth IRA to set up a long-term tax-free annuity for the daughter. But it didn't cost as much. Of course, for all this to work out as illustrated, the husband should designate the wife to be the beneficiary of the Roth IRA upon his death. At that point, the wife should declare the account her own by retitling the account in her name and designating the daughter as the beneficiary upon the wife's death. Finally, the daughter must begin taking minimum distributions by Dec. 31 of the year following her mother's death. Otherwise, the daughter will have to liquidate the account after five years, which would bring a premature end to all the fun associated with tax-free Roth IRA income.
For this strategy to make sense, two things must happen. First, the tax rules for Roth IRA rules must remain as they are now. Second, you must believe you won't need the money in the Roth IRA during your lifetime and that your heirs will pretty much leave the account alone, except when required to take minimum withdrawals to comply with the tax guidelines.
To the extent these assumptions prove untrue, the idea of using a Roth IRA to create a tax-free annuity for your heirs becomes that much less attractive. Remember, you are paying a high price -- the upfront conversion tax -- in order to set your heirs up for future tax savings that you hope will extend over many years.
If you do go for it, you probably won't be alone. In fact, another tax-law provision is intended to encourage even more well-off seniors to convert regular IRAs into Roth accounts. Starting in 2005, you won't have to include regular-IRA minimum withdrawals in your AGI for purposes of meeting the $100,000 limit for conversion eligibility. Congress anticipates a big jolt of conversion-tax revenue in 2005 and has already calculated it in its revenue projections for that year.