March 3, 2010
The Roth IRA: A Powerful Estate Planning Tool
Abstract: Those with savings in a traditional IRA, a 401(k) plan or another “qualified” retirement account must begin taking required minimum distributions (RMDs) when they reach age 70½. But it’s usually best to let them continue compounding on a tax-deferred basis (or tax-free in the case of Roth accounts) as long as possible. Fortunately, there are several strategies one can use to stretch tax savings over many years. Beginning in 2010, converting a traditional IRA to a Roth IRA will be an option for people of all income levels. One can also roll over a Roth 401(k) or Roth 403(b) to a Roth IRA. And a “stretch” IRA allows one to provide heirs with the opportunity to stretch distributions over many years. But these all have pros and cons that must be considered.
Being elastic can be fantastic
Stretch your retirement savings for yourself and your heirs
If you have a substantial amount of savings in a traditional IRA, a 401(k) plan or another “qualified” retirement account, you probably know that you must begin taking required minimum distributions (RMDs) when you reach age 70½. You probably also know that, unless you need the funds for living expenses, the best strategy is to let them continue compounding on a tax-deferred basis (or tax-free in the case of Roth accounts) as long as possible. Fortunately, there are several strategies you can use to achieve this objective.
The Roth conversion
Contributions to a traditional IRA can be tax deductible, but withdrawals are subject to ordinary income taxes. With a Roth IRA, on the other hand, your contributions aren’t deductible, but qualified withdrawals of contributions — as well as earnings — are tax free. And you’re not required to take RMDs from a Roth IRA, so converting can be an option to stretch your retirement savings.
Since the inception of Roth IRAs, Roth IRA conversions have been available only to people with modified adjusted gross income of $100,000 or less. But starting in 2010, conversion to a Roth IRA is available to taxpayers at all income levels.
Keep in mind that if you convert you’ll take a tax hit: It’s treated as if you withdrew the funds from the traditional IRA in a taxable (but penalty-free) distribution and reinvested them in a Roth IRA. If the value of your IRA investments has taken a beating in the current economy, making the conversion soon may allow you to minimize the tax hit. Plus, for conversions in 2010, you can opt to defer half of the taxable income to 2011 and the other half to 2012.
If you have a 401(k), 403(b) or other retirement plan, you’ll need to roll it over to a traditional IRA before you can make the conversion. You generally can make the rollover only after you’ve separated from the employer sponsoring the plan. As long as the rollover is done properly, no tax will be due on it.
The Roth rollover
If you have a Roth 401(k) or Roth 403(b) plan, consider rolling it over to a Roth IRA. Why? Because Roth 401(k)s and Roth 403(b)s still have RMDs. Even though you won’t have to pay tax on the distributions, you’ll lose out on the opportunity for continued tax-free growth on them.
There are no income limits on rollovers from a Roth 401(k) or Roth 403(b) to a Roth IRA. Similar to the rollover of a traditional 401(k) or 403(b) mentioned above, you generally can make the rollover only after you’ve separated from the employer sponsoring the plan. As long as the rollover is done properly, no tax will be due on it.
The stretch IRA
Designating a child or other young person as beneficiary of your retirement account allows you to provide your heirs with the opportunity to stretch distributions for many years — perhaps even over several generations. If you don’t designate a beneficiary or you name your estate as beneficiary, distributions will be accelerated after your death.
Bear in mind that, if you designate multiple beneficiaries, distributions will be based on the oldest beneficiary’s life expectancy — that is, the shortest life expectancy. You can avoid this result, however, by splitting your retirement plan into separate accounts for each beneficiary so that each beneficiary’s distributions are based on his or her own life expectancy.
If you wish to take advantage of this strategy, be sure that your IRA custodian permits — and is familiar with the concept of — the stretch IRA. Likewise, be sure that your 401(k) permits rollovers to a beneficiary other than a spouse.
The see-through trust
A disadvantage of the stretch IRA is that there’s nothing to prevent your beneficiary from taking more than the RMD, defeating the purpose of the technique. You can avoid this risk — and provide some creditor protection as well — by designating a trust as beneficiary of your retirement account, including a trust provision that account withdrawals are limited to RMDs, and naming your desired heir as trust beneficiary.
For this strategy to work, the trust beneficiary’s life expectancy must be recognized for RMD purposes. And for this to happen, the trust must qualify as a “see-through” trust. The rules for qualifying are complex, but the simplest approach is to use a “conduit” trust, under which the trustee is required to distribute any retirement account withdrawals to the trust beneficiary. Because the withdrawals are limited to RMDs, distributions from the trust will be relatively small.
Weigh your options
If you have a significant amount of wealth in IRAs or other retirement accounts, talk to your estate planning advisor about ways you can stretch out their tax benefits for years or generations to come.
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