Estate Planning with Roth IRAs

In Cash Flow and Budgeting, Estate Planning, Personal Financial Planning, Retirement Planning, Tax by Chip Hymiller

Roth IRAs are great savings mechanisms and can be used effectively for retirement and education planning.  One of the less publicized advantages to Roth IRAs is that they can be a great estate planning technique when someone wants to pass along as much as possible to their heirs.  

With Roth IRAs, income is earned tax-free, although there is not a tax deduction when the contribution is made.  Also, Roth IRAs are not subject to required minimum distribution rules as in the case of traditional IRAs.  However, once the account owner dies, the beneficiary is subject to required minimum distributions.  Let’s look at an example:

Assume Mr. Smith is age 65 when he converts his IRA to a Roth IRA (and pays tax on his low tax rates on the IRA distribution).  He never takes any withdrawals and dies at age 73.

Mrs. Smith inherits the Roth IRA and because she is a spouse, treats it as her own.  By doing so, she is not subject to required minimum distributions either.  She never takes any withdrawals and when she dies at age 83, her son, Junior, inherits the Roth IRA.

Now, Junior, because he is a non-spousal beneficiary, is subject to required minimum distributions, but the distributions are not subject to tax (it’s a good thing because he is in the highest tax bracket!).  Let’s say that he is 55 when he inherits the Roth.  The IRS says that his life expectancy is 29.6 years.  Junior decides to only take out the minimum distribution for each year (about $34,000 on a $1 million Roth IRA) and therefore preserves the Roth account’s tax-free earning power for as long as possible.

So in this example, the Roth IRA earned tax free income for a total of 47.6 years (8 years with Mr. Smith, 10 years with Mrs. Smith, and 29.6 years with Junior).  In effect, the Smiths took advantage of the Roth IRA rules to establish a tax-free income stream for their son!

That is a great deal for people who would like to leave their heirs with a significant portion of their estate and are concerned with the tax ramifications to their heirs.  If you want to talk more about how Roth IRAs fit into your estate plan or you are thinking of converting an IRA into a Roth IRA, give us a call.