By Thomas Rowley, Director of Retirement Business Strategy
Most investors' top priorities include providing for and protecting loved ones. An important part of preparing for the future involves finding tools that help add value to your estate, while maximizing your financial legacy. That's why you should consider the estate planning benefits of a Roth IRA conversion.
Understanding estate taxes
The threat of incurring estate taxes provides an incentive to reduce your taxable estate as much as possible. Federal estate taxes are triggered on your death if your taxable estate exceeds the federal exemption amount. Tax laws are subject to change, so exemption amounts and tax rates are not set in stone.1 Many states also have their own version of estate taxes.
How a Roth IRA conversion can help trim your estate
When you make a full conversion of a traditional to a Roth IRA, ordinary income taxes are due on the total amount converted in that tax year. Paying income taxes now on converted assets removes them from your taxable estate, thereby reducing its size. If you've accumulated considerable wealth, this can be an effective way to stay within the federal exemption amount and possibly reduce estate tax liability.
A strategy to keep assets intact for your heirs
One of the Roth IRA's key features is no required minimum distributions (RMDs) during your lifetime, which offers more growth potential if you prefer to pass on assets instead of spending them in retirement. If you stick with your traditional IRA, you will have to take RMDs beginning at age 70½, leaving you to pay taxes on the annual distributions and decreasing your investment. A Roth IRA conversion means paying taxes all at once, but the full value of your IRA is then positioned for potential future growth and eventual tax-free distribution to your heirs.
Roth IRA conversions can help reinforce your financial legacy
Traditional IRA assets that are passed to nonspousal beneficiaries, especially during their peak earning years, can result in a significant tax bill for these heirs. If you anticipate having a sizeable traditional IRA account balance upon your death, consider converting now to potentially provide your designated beneficiaries with tax-free access to a substantial sum of money. Roth IRA earnings can grow tax free, and earnings can be withdrawn tax free if you hold the conversion contribution for at least five years and you are age 59½ or older. Earnings can also be withdrawn tax and penalty free if they meet one of the other qualified distribution criteria [death, disability and qualified first-time homebuyer expenses (up to $10,000 limit)] and were held for at least five years.
Your heirs can withdraw earnings tax free regardless of their age or the age of the deceased account owner, as long as the Roth IRA conversion assets have existed for at least five years.2 Spousal beneficiaries can elect to treat the Roth IRA as their own but may not be able to withdraw earnings tax or penalty free until age 59½.
|Transferring wealth after converting to a Roth IRA
This hypothetical example illustrates how the tax-free earnings potential of a Roth IRA can be passed on to heirs over a long period of time.
|Husband converts traditional IRA to Roth IRA
- Designates his wife as sole beneficiary
- Pays taxes on conversion from savings account
- Does not need to use money for retirement
- Full IRA value can grow
- No mandatory withdrawals
|10 years later, husband dies
- Wife elects to transfer the Roth IRA into her name
- Designates her son as beneficiary
- Does not need to access money
- IRA can continue to grow
- Still no withdrawals required
|After 15 years, wife dies
- 55-year old son has life expectancy of 30 years
- Son must begin RMDs by Dec. 31 of the year following his mothers death
- Roth IRA continues to provide tax-free growth potential and withdrawals throughout his life
|Transfer and accumulation of potential tax-free wealth
- 10 years: husband's account
- 15 years: wife's inherited account
- 30 + years: son's RMDs
- 55 years: from conversion until end of payout
Many people confuse estate and gift taxes.
Estate tax: imposed when wealth is transferred after your death.
Gift tax: imposed when you transfer wealth during your lifetime.
The Unified Gift and Estate Tax system was established in the US as a way to ensure that money transferred during life does not escape estate taxes. Current tax laws do provide exemptions from these taxes.
Find out more from your advisors
Enhancing your financial legacy with a Roth IRA conversion can be a complex process. Rely on the guidance of trusted tax and financial professionals.