Use the Roth IRA as an estate planning tool

March 13, 2019

 

Key highlights

Converting client assets to a Roth IRA, rather than keeping them in a traditional IRA, can lead to significantly greater wealth accumulation over time.
The tax-exempt benefit to heirs of a Roth is especially important for those subject to the estate tax, because heirs who would have to pay the estate tax would also have to pay an income tax if they inherited a traditional IRA.
 

Note: As part of our Vanguard Advisor's Alpha® initiative, we are presenting three articles focused on using Roth accounts as part of estate planning. This first article in the three-part series is on using Roth IRAs to maximize wealth transfers.

Many clients hold substantial assets in tax-deferred retirement accounts, such as traditional IRAs and workplace retirement plans. Depending on their goals, clients may want to think about converting some of or all those assets to a Roth, either a Roth IRA or a Roth within a workplace retirement account. Discussions around conversions most commonly focus on retirement planning and expectations for current and future tax rates. However, clients may not understand that Roth IRAs can also serve as a vehicle in an estate plan to help them achieve—or amplify—their wealth-transfer goals.

"When an advisor is dealing with a bevy of estate planning concerns on behalf of a client, the potential in Roth accounts can be overlooked," said Garrett Harbron, senior manager, Vanguard Wealth Planning Research. "The long-term tax advantage may be there, and even if that is not always clear, the prospects of integrating Roths for heirs can prove worthwhile."

When clients convert from a traditional to a Roth IRA, they prepay the income taxes for beneficiaries. Additionally, if an estate is large enough to be subject to the federal estate tax, the conversion means heirs will not also have to pay income taxes on distributions, nor will they have to worry about tracking any cost basis, as they might with an inherited traditional IRA.

Both the growth within, and the qualified distributions from, a Roth account, of course, are not subject to income tax,1 making a Roth a valuable structure for estate planning.

Potential to transfer greater after-tax wealth

From a wealth-transfer perspective, Roth IRAs have two advantages over traditional IRAs.

First, they do not require account owners to take required minimum distributions (RMDs) during their lifetime. The amounts that would be paid out in RMDs and subject to income tax in a traditional IRA can continue to grow in a Roth IRA tax-exempt. This could result in a greater account balance when the Roth IRA is ultimately transferred to beneficiaries.

Second, qualified Roth distributions are tax-exempt: No income tax is due when withdrawals are taken.

These features can substantially increase after-tax wealth for beneficiaries.

How clients pay the taxes due at conversion can also have a significant impact. Roth conversions may be either tax-exclusive or tax-inclusive. If clients pay the taxes due with assets outside the IRA, the conversion is tax-exclusive. This is often the better strategy because it transfers the entire pre-tax IRA balance to the Roth account, essentially increasing its after-tax value. On the other hand, in a tax-inclusive conversion, the income tax is paid from the traditional IRA and the beginning value of the Roth is reduced accordingly.2

Hypothetical scenarios

Consider a hypothetical 65-year-old client with a taxable account balance of $24,000, a traditional IRA balance of $100,000, and a 40-year-old nonspouse beneficiary. In the following three scenarios, the account owner and beneficiary are in a 24% tax bracket, and the beneficiary inherits the IRA and the taxable account 20 years after each scenario begins. The figure below shows the combined after-tax liquidation value of the IRA and the taxable account over time for the scenarios. For simplicity, we assume that no estate taxes are due at the account owner's death and that the income tax rate for both parties remains constant.

Scenario 1—No Roth used: The account owner reinvests all income and dividends in both accounts. She begins taking RMDs from the traditional IRA at age 70½ and reinvests the after-tax proceeds in her taxable account. Upon inheriting the IRA, her beneficiary begins taking RMDs according to his life expectancy—as is legally required—and reinvests them, net of taxes, into the taxable account.

Scenario 2—Use a Roth, and pay taxes from the Roth: The account owner converts the entire traditional IRA to a Roth IRA at age 65 and pays the conversion taxes from the IRA while maintaining the taxable account (a tax-inclusive Roth conversion), leaving her with a $76,000 Roth IRA and a $24,000 taxable account. She does not take any withdrawals from the Roth IRA during her lifetime. Upon inheriting the Roth IRA, her beneficiary takes RMDs (exempt from income tax) based on his life expectancy and invests them in the taxable account.

Scenario 3—Use a Roth, but pay taxes from a source other than the Roth: Identical to Scenario 2, except the account owner pays the conversion taxes using the money in her taxable account (a tax-exclusive Roth conversion with the full balance converted), leaving her with $100,000 in her Roth IRA and no balance in her taxable account.

As the figure below shows, converting to a Roth can lead to greater after-tax wealth being passed on to the client's beneficiary. This is especially true if the taxes on the conversion are paid with funds outside the IRA. Converting to a Roth initially reduces total wealth by the amount of the income taxes paid. However, because RMDs are not required during the account owner's lifetime, the balance of the Roth IRA may be drawn down more slowly than what would happen with a traditional IRA. This means more of the Roth IRA can benefit from tax-exempt compounding for longer, possibly resulting in significantly more wealth over time.

A tax-exclusive Roth conversion may result in more wealth

A tax-exclusive Roth conversion may result in more wealth

Notes: Amounts shown are the after-tax liquidation value of the accounts at the end of each year. Assumes a 6% annual rate of return on a 50% equity/50% fixed income portfolio, with all income and dividends reinvested. Portfolio returns consist of 3.3.% from capital gains and 2.7% from income, including 1% from dividends, which is consistent with the historical average breakdown of returns on a 50/50 portfolio. Distributions from the traditional IRA and income received within the taxable portfolio are taxed at a rate of 24%, dividends and capital gains in the taxable portfolio are taxed at a rate of 15%. Assumes the portfolio is rebalanced annually within the tax-advantaged account and/or using portfolio cash flows with no turnover in the taxable account. Liquidation values ignore the five-year holding period for Roth IRAs.

Other estate planning advantages

Besides potentially passing greater wealth on to beneficiaries, a Roth conversion may also provide two important estate planning advantages (see figure below):

• Elimination of double taxation. If an estate is large enough to incur the estate tax,3 the beneficiaries must pay those taxes on all assets beyond the exemption amount, including tax-deferred assets such as traditional IRAs, employer-based retirement plans, and annuities. They must also pay income tax on any withdrawals from these accounts, resulting in double taxation.4 Thus, it is generally more advantageous to pass on assets that do not have an embedded income tax liability, such as a Roth IRA or taxable assets.

• Reduction of the estate through income tax on the conversion. Upon conversion, the estate is reduced by the conversion taxes paid and any future appreciation of those dollars. Even if the reduction isn't large (and many individuals are not subject to the estate tax at all), using this method does not reduce the owner's gift/estate tax exemption.

However, because the client's estate will include the Roth IRA (and its potential growth), a Roth conversion may increase a taxable estate over time, possibly beyond the savings achieved by converting. For those with sizable estates, it is especially important to consider all the implications before deciding when, or if, to convert to a Roth.

Tax impact on investors and beneficiaries of traditional vs. Roth IRA

Tax impact on investors and beneficiaries of traditional vs. Roth IRA

Click to read the next story in the series.

1 To be considered qualified, distributions must occur at least five years after the first contribution to a Roth IRA for the owner's benefit. For converted IRAs, a separate five-year holding period applies for each, starting on the first day of the calendar year for each conversion. Additionally, the owner must be at least age 59½ or disabled at the time of the distribution, or the distribution must be made to a beneficiary or the owner's estate after the owner's death. Other exceptions exist. See IRS Publication 590-B for details.

2 Note that if a client makes a tax-inclusive conversion before age 59½, the taxes paid from the IRA could be considered a premature withdrawal subject to income tax and an additional 10% penalty.

3 For 2019, the federal gift and estate tax exemption is $11.4 million per individual. Lifetime gifts that use a portion of or all this exemption are deducted from the estate tax exemption amount when calculating the taxable estate. Any assets held by the estate in excess of the remaining exemption are taxed at a maximum rate of 40%.

4 An income tax deduction based on the estate tax paid on the IRA is available for beneficiaries in this situation. However, it is unlikely the deduction will entirely offset the required distributions from the IRA, and in practice, most beneficiaries fail to take advantage of it.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. We recommend that you consult a tax or financial advisor about your individual situation.
  • For more information about Vanguard funds, visit advisors.vanguard.com or call 800-997-2798 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

 

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