The Roth IRA Advantage: A Closer Look
Since its debut in 1997, the Roth IRA, naturally enough, has been sold mainly as
a retirement account. To be sure, the prospect of a stream of tax-free income
to support a comfortable retirement is a powerful stimulant.
To earn that freedom from taxes, you do have to pay income tax on the dollars that
go into a Roth IRA. There are requirements for participation that differ in many
respects from those of traditional deductible IRAs. However, if you qualify for
a deductible IRA, you can do nearly as well (in some cases, even better than with
a Roth). It does take some savings discipline. You would need to invest your tax
savings in a taxable account, the proceeds of which will help pay taxes on your
So, building a retirement nest egg is not what makes Roth IRAs so special . . .
The real big deal
The true attraction of the Roth IRA is the financial freedom that it can provide
over the long term. In a Roth IRA there’s no requirement to begin taking withdrawals
at age 701/2 or at any point in your lifetime. You even can continue making annual
contributions as long as you have earned income.
Money remaining in your account at your death passes to your named beneficiary free
of income taxes. And your heir can choose to spread out tax-free withdrawals over
his or her own life expectancy. These features can enable some impressive long-term
building of wealth.
When you are in the happy position of not needing a portion of the assets in your
retirement accounts, the Roth IRA is an especially attractive estate planning tool.
Moving retirement account assets into a Roth IRA, you’ll pay income tax on the balance
transferred. This removes the amount of the tax from your estate and shelters all
future growth from income taxes.
To illustrate, we’ll consider the hypothetical case of a man we’ll call George.
Having reached age 70, George retired this year with a generous pension plan and
a large stock portfolio. He also has $100,000 in an IRA rolled over from a profit
sharing plan. He knows that he’ll have to start taking distributions right away,
but he would prefer to leave the account intact for his named beneficiary, his 40-year-old
daughter, Shirley. (All calculations used in this illustration assume annual investment
returns of 6%.)
If George stays in the IRA, he’ll begin taking minimum distributions based on final
regulations published in April 2002 by the IRS—a 27.4-year distribution period at
age 70, recalculated each year to minimize the size of the required distributions.
When George dies at age 85, before taking his required distribution for the year,
he will have received a total of $82,514 (pretax), and Shirley will inherit an IRA
with a balance of $125,912.
That’s a handsome sum, and one that Shirley can enhance by taking minimum distributions
over her own life expectancy, according to IRS rules. At age 92, for example, Shirley
will have received a total of $377,513 and still have more than $40,000 in the account.
However, as was the case for George, every penny of her withdrawals will be taxed
as ordinary income.
The Roth advantage
If George converts the account to a Roth IRA instead, selling enough stock to cover
the tax liability, Shirley does much better. She’ll inherit a Roth IRA with a balance
of $254,035. Using the same age as above, at 92 Shirley will have collected $773,587
tax free. And she still would have nearly $90,000 in the account. The conversion,
at a cost of perhaps $40,000, will have gained Shirley and her heirs more than half
a million dollars.
Of course, it’s not quite that simple. To start with, not everyone can make a Roth
conversion. Under current rules you can make a conversion only in a year in which
your adjusted gross income does not exceed $100,000. (The amount of the conversion
does not count toward this AGI limit.) Strangely, the same cap applies both to married
couples filing jointly and to individual filers.
Roth IRA beneficiaries must make the election to take withdrawals over their life
expectancies no later than December 31 of the year following the account owner’s
death. If they don’t, they must drain the account within the five years following
the year of death.
Both traditional and Roth IRAs are included in the estate of the owner and can be
subject to estate taxes. In the year 2004 as much as $1.5 million can be exempt
from estate tax, and this amount will rise substantially over the coming years.
To ensure the wealthbuilding potential of an inherited Roth IRA, provision should
be made to pay any “death” taxes from other sources.
To date, much of the action in Roth conversions has centered around younger investors,
seduced by the prospect of tax-free retirement income. The Roth IRA’s use for wealth
transfer has not been fully exploited yet by those in or approaching retirement.
If the secret gets out, that situation may change dramatically.