Roth IRAs Provide Valuable Tool to Estate Planners

By Ann Siford , Professional Network Manager, Equity Trust Company
7/22/09

With the 2010 Roth conversion opportunity making the Roth IRA available to high net-worth clients, more and more investors are realizing the substantial benefits of the Roth as a retirement planning tool. Unlike a traditional IRA, a Roth is funded with after-tax dollars, earnings grow tax-free and distributions are tax-free after the account has been open for five years and the owner is over age 59 ½.

Not as well known, however, are the potential benefits of a Roth IRA as an estate planning tool. “The Roth IRA gives individuals the opportunity to leave their heirs a benefit that’s more valuable than a dollar of cash,” says Michael J. Jones, a partner with Monterey, California’s Thompson Jones, LLP and a member of the Equity Trust Professional Network. “It provides heirs with a lifetime of tax-free returns, which are the Holy Grail of investing.”

Earnings and tax-deductible contributions to traditional IRAs are subject to federal and state income taxes upon withdrawal, regardless of whether the withdrawal is made by the original account holder or his heirs. So passing on assets via a Roth IRA instead of a traditional IRA can potentially save heirs tens or even hundreds of thousands of dollars in taxes over their lifetime.

Roth IRAs and RMDs

Another big estate planning benefit of Roth IRAs is the fact that they are not subject to Required Minimum Distributions (or RMDs) as traditional IRAs are. Individuals who don’t need the money can leave it in a Roth IRA, where it can keep growing for the benefit of their heirs - without being reduced by income taxes and required minimum distributions. Once the individual dies, however, his or her heirs must start making RMDs from the Roth IRA. But if they don’t need the money right away, they can preserve the account for many years by keeping these distributions as low as possible. An example helps illustrate:

John, who has been faithfully contributing to his Roth IRA since Roths were conceived in 1997, has just died at age 65. His account will pass directly to his wife Jane, also 65, who can treat the account as if it were her own. Jane then lives to the age of 85 without taking any distributions, passing the account on to their daughter Jenny, who is 50.

The IRS’s life expectancy tables say that Jenny should live to age 85, or another 35 years, so she must make RMDs each year based on this life expectancy. By taking out only the required minimum, however, she can preserve the IRA’s tax-free earning power for as long as possible. In this case, the Roth IRA would have been maintained and preserved for a total of 67 years - 12 with John, 20 with Jane and 35 with Jenny.

Educating Your Heirs

Getting heirs to understand this concept and agree to keep their distributions to a minimum isn’t always easy. “For this strategy to work, you often must do one of two things: Educate heirs and help them get comfortable with the idea, or use a trust,” explains Jones. “You can construct the trust so heirs only receive required minimum distributions each year, or whatever amount you decide they may need. This can give you some assurance that only RMDs will be withdrawn if that’s what you desire.”

All other things being equal, younger beneficiaries will receive more benefit from this strategy than older ones, which makes it ideal for generation-skipping transfers, especially for larger estates. “The younger the beneficiary, the smaller the RMD,” Jones notes. “For example, a 20-year old grandchild could stretch Roth IRA distributions out for 63 years, while a 10-year old could stretch them out for 73 years,” based on current IRS life expectancy tables.

Other Considerations

Individuals should make sure heirs won’t have to withdraw funds from an inherited Roth IRA to meet liquidity needs—to pay estate taxes and administration fees or debts, for example.

“It’s usually better to purchase a life insurance policy that will cover these expenses, rather than having to dip into the Roth IRA,” Jones explains. “Life insurance has its own internal rate of return and it helps protect the Roth. Once you take money out of a Roth IRA, you’ve lost the benefit of future tax-free income on the money you’ve withdrawn.”

He also points out that an inherited Roth IRA must be transferred from the decedent’s account into a new “inherited” or “beneficiary” account. “The money is at risk every time it’s in transit, so every step of the transfer should be watched very carefully. A blown transfer is a blown Roth IRA. Once the money ends up in a taxable account, there’s no fix, unless the beneficiary is a surviving spouse.”

Ann Siford is Manager of the Professional Network at Equity Trust Company, a custodian specializing in the investment of retirement funds in alternative assets. The Professional Network provides professionals in the self-directed retirement account industry with educational resources, access to expertise from peers and industry experts and targeted promotional tools to aid in expanding their business.

For more information on the Professional Network, contact Ann at 1-888-382-4727 x255 or visit http://www.trustetc.com/pronetwork to sign up.

Disclaimer: Equity Trust is a passive custodian and does not provide tax, legal, or investment advice. It does not endorse or recommend any contributor, company, or specific investments. Any information communicated by Equity Trust Company is for educational purposes only and should not be construed as tax, legal, or investment advice. Whenever making an investment decision, please consult with your legal, tax, and accounting professionals.