The Roth IRA: A Useful Estate-planning Tool

By Clifton Linton
Senior Writer, mPower

In this story: The Tax Man Cometh Avoid the Tax Man Reduce Probate Legal Hassles Passing Eligibility Rules Other Considerations

The only two certainties in life, as the old saying goes, are death and taxes. And in the U.S., to the ire of your heirs, the taxman gets to one-up the grim reaper by taxing your assets after your death.

Some retirees are turning to an unlikely estate-planning tool to protect their money from being decimated by estate taxes – the Roth IRA. While it’s not for everyone, converting to a Roth IRA in your later years could help save your heirs money.

minute: read this article at a glance.

If you want to pass on a sizable estate to your family or others, it's likely that your biggest concern should be "How can I minimize their tax bite?"

Think Roth IRA. This tax-deferred savings tool is not only a great way to build a retirement nest egg but also a valuable estate-planning tool. By using one, your heirs will be singing your praises long after you've gone.

Let's take a look at how to use a Roth to help you preserve your estate.

The Tax Man Cometh

When you die, the tax collector gets to go to the head of the line when your estate, consisting of all your belongings, is portioned out. If your estate is worth more than $675,000, the minimum threshold for estate taxes, when you die, he'll be grinning from ear to ear.

This is because your heirs will have to pay at least 30% of your estate's value in taxes, certified financial planner Bob FitzSimmons added. On top of that, any income they receive from the estate such as cash, 401(k) payouts, or traditional IRA balances, will be taxed at their regular tax rate. If your heir's income falls into the 28% tax bracket, when you add that to the estate taxes, the government could take at least 58% of this income.

It could even be worse. "You can lose 60% to 80% of the value of an (traditional) IRA" to estate and income taxes, warned FitzSimmons, a board member of the Financial Planning Association.

Avoid the Tax Man

Many retirees can use a Roth as an estate-planning tool either, to reduce or eliminate their heir's estate taxes or, to keep it from being held up with the rest of the estate in probate.

Eliminating estate taxes requires you to have an IRA worth about $1 million and an estate worth only about $70,000 more. To obviate estate taxes, you could convert the IRA to a Roth. You will be taxed at the highest tax rate of 39%, paying about $400,000 in income taxes for the year. By rolling the remaining $600,000 into the Roth, the value of your estate will fall to $670,000 and your heirs won't have to pay estate taxes. While this may seem like a big tax hit all at once, the advantage is that down the road neither you nor your heirs will have to pay income tax on withdrawals from the Roth.

If you have your money in a 401(k) plan, there's an extra step involved. You must first roll your 401(k) money into a traditional IRA and then convert that into a Roth IRA. You can't directly roll over 401(k) money into a Roth IRA account.

"When you switch a traditional IRA to a Roth, you pay the tax up front. The tax is out of the estate." — Barry Picker, certified public accountant and certified financial planner

"When you switch a traditional IRA to a Roth, you pay the tax up front. The tax is out of the estate," explains Barry Picker, a certified public accountant and certified financial planner.

Just remember, in order for withdrawals from a Roth to be tax free, the account needs to have been open for five years and you need to be over 59½. The tax-free protection is extended to folks who inherit a Roth IRA as well.

Reduce Probate Legal Hassles

Like insurance benefits, Roth IRA proceeds are passed on by beneficiary designation — they aren't included in a will.

"You name the beneficiary or beneficiaries. The account passes by operation of law to the beneficiary. That means the Roth IRA can pass the probate court process and save fees, unwanted publicity, and potential delay," said Neil Downing, a certified financial planner and author of Maximize Your IRA.

This won't, however, completely bulletproof your assets from a lawsuit. "Legal actions can be brought at any time by anybody," he said.

How to Turn a Roth into a Lifetime Stream of Income If you inherit a Roth IRA, and want to use it to generate a lifetime stream of income, you need to take your first withdrawal by December 31 of the year after the IRA owner's death. If you don't, you'll have to withdraw the entire balance of the account within five years of the original owner's death.

The beneficiary naming rules are also easier with Roth IRAs than with traditional IRAs. With a traditional IRA, you aren't allowed to change your beneficiary designation after you reach the age of 70½. That can make things sticky if your spouse is the named beneficiary and he or she dies before you. After your death, the heirs must liquidate the IRA within one year.

With a Roth, you can change your beneficiary designation at any time. But don't name your estate as the beneficiary, Picker warns. If you do that, your heirs will be forced to take the proceeds of your Roth as a lump sum.

Passing Eligibility Rules

If you don't already have one, there are two ways to open a new Roth IRA. You could convert a regular IRA to a Roth or you could start a new Roth account. In both cases, you must pass eligibility rules before opening the account.

You won't be able to convert a traditional IRA to a Roth if you earned more than $100,000 in annual-adjusted gross income. However, for many retirees living on a fixed income, that may not be a concern.

To open a new Roth, you need to meet a different set of eligibility rules. If you're single and earned more than $110,000, or married, filing jointly and earned more than $160,000, you won't be able to open a new Roth IRA. This eligibility test doesn't affect previously held Roth IRA accounts.

Other Considerations

A Roth has no minimum-required distribution rule. If you don't need the money, you can just leave it alone and let it continue growing, Picker said. Traditional IRAs and 401(k) plans require workers to take a minimum-required distribution the year after they reach the age of 70½. (Although with a 401(k), if you are still working for the employer who sponsors the plan, you don't have to start taking minimum distributions until you retire.)

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

The Roth IRA: A Useful Estate-planning Tool

By Clifton Linton
Senior Writer, mPower

In this story: The Tax Man Cometh Avoid the Tax Man Reduce Probate Legal Hassles Passing Eligibility Rules Other Considerations

The only two certainties in life, as the old saying goes, are death and taxes. And in the U.S., to the ire of your heirs, the taxman gets to one-up the grim reaper by taxing your assets after your death.

Some retirees are turning to an unlikely estate-planning tool to protect their money from being decimated by estate taxes – the Roth IRA. While it’s not for everyone, converting to a Roth IRA in your later years could help save your heirs money.

minute: read this article at a glance.

If you want to pass on a sizable estate to your family or others, it's likely that your biggest concern should be "How can I minimize their tax bite?"

Think Roth IRA. This tax-deferred savings tool is not only a great way to build a retirement nest egg but also a valuable estate-planning tool. By using one, your heirs will be singing your praises long after you've gone.

Let's take a look at how to use a Roth to help you preserve your estate.

The Tax Man Cometh

When you die, the tax collector gets to go to the head of the line when your estate, consisting of all your belongings, is portioned out. If your estate is worth more than $675,000, the minimum threshold for estate taxes, when you die, he'll be grinning from ear to ear.

This is because your heirs will have to pay at least 30% of your estate's value in taxes, certified financial planner Bob FitzSimmons added. On top of that, any income they receive from the estate such as cash, 401(k) payouts, or traditional IRA balances, will be taxed at their regular tax rate. If your heir's income falls into the 28% tax bracket, when you add that to the estate taxes, the government could take at least 58% of this income.

It could even be worse. "You can lose 60% to 80% of the value of an (traditional) IRA" to estate and income taxes, warned FitzSimmons, a board member of the Financial Planning Association.

Avoid the Tax Man

Many retirees can use a Roth as an estate-planning tool either, to reduce or eliminate their heir's estate taxes or, to keep it from being held up with the rest of the estate in probate.

Eliminating estate taxes requires you to have an IRA worth about $1 million and an estate worth only about $70,000 more. To obviate estate taxes, you could convert the IRA to a Roth. You will be taxed at the highest tax rate of 39%, paying about $400,000 in income taxes for the year. By rolling the remaining $600,000 into the Roth, the value of your estate will fall to $670,000 and your heirs won't have to pay estate taxes. While this may seem like a big tax hit all at once, the advantage is that down the road neither you nor your heirs will have to pay income tax on withdrawals from the Roth.

If you have your money in a 401(k) plan, there's an extra step involved. You must first roll your 401(k) money into a traditional IRA and then convert that into a Roth IRA. You can't directly roll over 401(k) money into a Roth IRA account.

"When you switch a traditional IRA to a Roth, you pay the tax up front. The tax is out of the estate." — Barry Picker, certified public accountant and certified financial planner

"When you switch a traditional IRA to a Roth, you pay the tax up front. The tax is out of the estate," explains Barry Picker, a certified public accountant and certified financial planner.

Just remember, in order for withdrawals from a Roth to be tax free, the account needs to have been open for five years and you need to be over 59½. The tax-free protection is extended to folks who inherit a Roth IRA as well.

Reduce Probate Legal Hassles

Like insurance benefits, Roth IRA proceeds are passed on by beneficiary designation — they aren't included in a will.

"You name the beneficiary or beneficiaries. The account passes by operation of law to the beneficiary. That means the Roth IRA can pass the probate court process and save fees, unwanted publicity, and potential delay," said Neil Downing, a certified financial planner and author of Maximize Your IRA.

This won't, however, completely bulletproof your assets from a lawsuit. "Legal actions can be brought at any time by anybody," he said.

How to Turn a Roth into a Lifetime Stream of Income If you inherit a Roth IRA, and want to use it to generate a lifetime stream of income, you need to take your first withdrawal by December 31 of the year after the IRA owner's death. If you don't, you'll have to withdraw the entire balance of the account within five years of the original owner's death.

The beneficiary naming rules are also easier with Roth IRAs than with traditional IRAs. With a traditional IRA, you aren't allowed to change your beneficiary designation after you reach the age of 70½. That can make things sticky if your spouse is the named beneficiary and he or she dies before you. After your death, the heirs must liquidate the IRA within one year.

With a Roth, you can change your beneficiary designation at any time. But don't name your estate as the beneficiary, Picker warns. If you do that, your heirs will be forced to take the proceeds of your Roth as a lump sum.

Passing Eligibility Rules

If you don't already have one, there are two ways to open a new Roth IRA. You could convert a regular IRA to a Roth or you could start a new Roth account. In both cases, you must pass eligibility rules before opening the account.

You won't be able to convert a traditional IRA to a Roth if you earned more than $100,000 in annual-adjusted gross income. However, for many retirees living on a fixed income, that may not be a concern.

To open a new Roth, you need to meet a different set of eligibility rules. If you're single and earned more than $110,000, or married, filing jointly and earned more than $160,000, you won't be able to open a new Roth IRA. This eligibility test doesn't affect previously held Roth IRA accounts.

Other Considerations

A Roth has no minimum-required distribution rule. If you don't need the money, you can just leave it alone and let it continue growing, Picker said. Traditional IRAs and 401(k) plans require workers to take a minimum-required distribution the year after they reach the age of 70½. (Although with a 401(k), if you are still working for the employer who sponsors the plan, you don't have to start taking minimum distributions until you retire.)

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.