Idea: Roth IRAs as an Estate Planning Tool


Roth IRAs are a great tax saving tool. The reason: Investments held in a Roth IRA are allowed to build up federal-income-tax-free. Later on, you can take federal-income-tax-free withdrawals. Obviously, a zero tax rate is the best rate going.

In addition to being great tax saving tools for retirement, Roth IRAs also provide tremendous estate planning advantages — especially if you can get a large portion of your wealth into an account.

Unfortunately, getting lots of money into a Roth IRA is not so easy. It can take many years of annual contributions. However, there’s also one very quick way — by converting an existing traditional IRA or SEP account into a Roth IRA. There are no limitations on the size or number of converted accounts. Naturally, under tax law, there is a price for allowing you to jump start your Roth IRA savings program with a conversion. Even so, it may be worth the price.

Roth Conversion Basics

A Roth conversion is treated as a taxable distribution from your traditional IRA. In other words, you’re deemed to receive a taxable cash payout from your traditional IRA with the money going into the new Roth account. So the conversion triggers a current income tax bill. In most cases, however, this negative factor is outweighed by the following positive factors.

  • You don’t have to pay the 10% premature withdrawal penalty tax on the deemed distribution that results from the Roth conversion transaction. This is true even if you’re under age 59 1/2 when the conversion takes place.
  • Your conversion tax bill is significantly lower, thanks to the individual income tax rate cuts brought by the Tax Cuts and Jobs Act, for single taxpayers with taxable incomes of less than $500,000 or for married joint filers, $600,000. No one knows whether tax rates could go up in the future, of course, but now could be a good time for a Roth conversion.
  • The value of the traditional IRA (or IRAs) you want to convert may still be down because of poor investment performance in recent years. However, a lower account balance means a lower conversion tax bill.

Now for the Estate Planning Angle

The usual reason for converting a traditional IRA into a Roth account is to earn tax-free income that will be withdrawn after age 59 1/2 to help finance your retirement. But if you don’t really need the money for retirement, there’s another less-publicized advantage to converting. Let’s say you would like to pass along as much wealth as possible to your heirs. If so, a Roth conversion transaction can be a great estate planning technique for you.

Don’t misunderstand. Roth IRA balances are not exempt from the federal estate tax (nor are traditional IRA balances). However by paying the up-front Roth conversion tax bill, you effectively prepay your heir’s future income tax bills while reducing your taxable estate at the same time. And this prepayment of income tax doesn’t result in any gift tax or diminish your $11.4 million federal gift tax exemption for 2019 (up from $11.18 million in 2018) or any federal estate tax exemption.

But there is even more to pass on to your heirs. A big advantage of Roth accounts is they are not subject to the required minimum distribution rules that apply to traditional IRAs. These rules force the account owner to begin liquidating his or her IRA after turning age 70 1/2. Of course, this means Uncle Sam and state tax collectors take their cut in the form of taxes on the distributions. When you don’t need the IRA money, being forced to take these required minimum distributions and pay the resulting income taxes can be pretty costly.

But converting a traditional IRA into a Roth account stops required minimum distributions. Once a conversion is complete, you are free to leave the account balance untouched and accumulate as many tax-free dollars as possible to pass along to your heirs.

However, the required minimum distribution exemption ends when you die. At that point, the Roth IRA falls under a set of the required minimum distribution rules that apply to all inherited IRAs (traditional and Roth). If your heirs are disciplined enough to take only the annual required minimum distribution amounts from the inherited Roth IRA, the account liquidation process can be strung out for many years, as the following example illustrates.

Example: A taxpayer is 65 when he converts a traditional IRA into a Roth account. He lives for eight more years and never takes any withdrawals. The taxpayer’s wife is age 70 when he dies. She inherits the Roth IRA because she is the designated account beneficiary.

According to the IRS single life expectancy table, the wife can expect to live another 17 years. Under the required minimum distribution rules, she can treat the inherited Roth account as her own, so she is not required to take any minimum distributions during her lifetime. Assume she doesn’t take out a dime. At age 87, the wife dies and leaves the Roth IRA to the couple’s daughter, who was designated as the new account beneficiary after the husband died and wife took over the account.

At that point, the daughter is 55-years-old. The IRS single life expectancy table states she should live for another 30 years. She must start taking required minimum distributions and gradually liquidate the inherited Roth IRA over that 30-year period. Of course, all of her withdrawals will be free of any federal income tax. (Her father effectively prepaid the federal income tax bill at the time of the original Roth conversion transaction many years earlier.)

Assume the daughter is smart enough to take out only the required minimum distribution amount for each year. By doing so, she preserves the inherited Roth account’s tax-free earning power for as long as possible (30 years in this case, assuming she lives to her statistically expected age).

So under the facts in this example, the Roth IRA is allowed to earn tax-free income for a total of 55 years: 8 years with the husband, 17 years with the wife, and 30 years with the daughter. That’s pretty good mileage for the account considering the account owner was 65 when he made the Roth conversion transaction.

What happened in this example? In effect, the husband and wife took advantage of the Roth IRA rules to establish a nice federal-income-tax-free annuity for their daughter.

For this planning technique to work as it does in the above example, you must take four steps:

Step 1 – Designate your spouse as the Roth IRA beneficiary before you die.

Step 2 – After your death, your spouse must treat the account as his or her own by re-titling it in his or her name.

Step 3 – Your spouse must also name your child as the new Roth IRA beneficiary.

Step 4 – Finally, your child must begin taking annual required minimum distributions by no later than December 31 of the year following the year of your spouse’s death. Otherwise, your child will be required to liquidate the inherited Roth IRA after only five years, which would end the tax-free strategy prematurely.

As you can see, a Roth IRA can be a great estate planning vehicle. However, before implementing this strategy, get professional advice about the conversion tax consequences and the estate planning considerations.

PKS & Company, P.A., Certified Public Accountants and Advisors to Business, is a full service accounting firm with offices in Salisbury & Ocean City, MD and Lewes, DE.  PKS  provides traditional accounting services as well as specialized services in the areas of retirement plan audits and administration, medical practice consulting, estate and trust services, fraud and forensic services and payroll services and offers financial planning and investments through PKS Investment Advisors, LLC

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