Roth IRA's may sound like a great idea for passing wealth to family members—the funds essentially can grow tax-free over your lifetime and theirs. But, before you rush to convert all or part of a traditional retirement account to a Roth for your loved ones, take a long hard look.
Roth conversions- account holders converting a traditional IRA to a Roth, ostensibly in order to capture the benefit s of tax-free, rather than tax deferred growth, often rely upon a common supporting "story" that requires estate taxes (quite avoidable with good planning), high income taxes on the IRA at death (also for which good planning can make a difference), and healthy returns on the Roth investment to pay the investor back for taxes paid making the conversion(which are sometimes unrealistic, especially over time). It is not uncommon for consumers to believe that their traditional IRA's will suffer extraordinary taxes upon death, 50-75% in many cases! While unquestionably those with large IRA's and estates exceeding five million dollars may witness such excessive tax consequence (federal estate tax, state estate tax, federal income tax, state income tax), the reality for most taxpayers is, fortunately, less severe.
Roth IRAs are not always a good way to pass wealth. Whether such a conversion makes sense depends heavily on tax rates—of both the account owner and heirs—and whether lawmakers approve proposed rule changes that could eliminate some of the estate-planning perks of Roths.
Many people use Roths for bequests because account holders don't have to start taking distributions at age 70½ as they do with traditional IRAs. The money can sit untouched and grow tax-free throughout the owner's lifetime—a big plus for those who don't need the assets to live on. And while those who inherit any type of IRA must start taking distributions immediately, they are permitted to stretch out those payments over their lifetime, allowing the bulk of a Roth account to continue growing tax-free.
Two proposals in President Obama's 2015 budget, if approved, would change all that.
The first would require Roth owners to start taking distributions at age 70½. If that happens the Roth IRA would typically be rendered bereft of value by the time an account holder could leave the asset to an heir.
The second would end the ability of nonspousal IRA beneficiaries to stretch distributions. Instead, inherited IRAs would have to be disbursed within five years of the owner's death.
That proposal, if enacted, would reduce the estate-planning benefits of Roths. Contributions to Roths are made with after-tax money, while withdrawals are tax-free as long as certain rules are met. The opposite is true of traditional IRAs: Contributions are pretax, and withdrawals are taxed. As such, the owner of a traditional IRA pays a hefty upfront tax bill to convert to a Roth.
"If there's no stretch IRA, it doesn't pay for an older person to convert to a Roth," says Ed Slott, founder of IRAHelp.com. "Why should someone 60, 70 years old, who's mainly doing it for their beneficiaries, pay a tax when the deferral rate after they die is limited to five years?"
Whether these proposals become law remains to be seen.
Regardless, there are other issues people need to consider before converting to a Roth to benefit heirs. Tax rates—what you pay at the time of conversion compared with what you or your heirs would pay on distributions from a traditional IRA—are a critical part of the equation. If your tax rate when you convert is the same as the rate you or your heirs would pay on distributions from your traditional IRA, the decision is easy: Roths have a slight advantage. But the Roth's lead is trumped if the beneficiary's tax rate is lower than the account owner's. For example, if you convert to a Roth in California, which levies an income tax, and leave the account to a child in Texas, where there is no state income tax, the Roth advantage is easily overwhelmed.
If your tax rate is higher now than your heir's would be when taking distributions from a traditional IRA, a Roth conversion unnecessarily eats into your heir's inheritance. A conversion that is taxed at 39.6% tax eats heavily into an inheritance. Still, for retirees who are now enjoying low tax rates, one or a series of surgical conversions can make sense, provided the conversion does not cause the taxpayer to jump to the highest tax brackets.
Getting a handle on future tax rates isn't always easy. Income tax rates don't always track higher, and sometimes an heir's tax burden might structurally be higher or lower regardless. If, for example, there are marked differences in tax rates between you and your heirs due to career choices or other reasons, these rates may be easier to predict. But, don't forget the addition of inherited, and possibly income-generating assets altering the rates of your heir's tax burden.
Finally, the Supreme Court recently decided that inherited IRAs are not protected from a beneficiary's creditors, so those worried about their children's ability to avoid bankruptcy might look to a trust or non-IRA vehicle for bequeathing assets.
This article is heavily based on an article written by Andrea Coombes, published here.
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