How a Roth Conversion Can Benefit Your HeirsBy Mark Fissel
Posted on October 3rd, 2016
If you have an individual retirement account (IRA), you probably already know about required minimum distributions (RMDs). For traditional IRAs, including Simplified Employee Pension (SEP) or a Savings Incentive Match Plan for Employees (SIMPLE), you must take your first RMD in the year you turn 70½ or by April 1st of the following year from when you reach 70½.
Converting your traditional IRA to a Roth IRA can help you avoid RMDs and significantly benefit your children and grandchildren.
The conversion is treated as a taxable distribution, meaning you’ll owe income taxes on the amount converted in the year you convert, and the rate might be lower if you are already retired. Roth IRAs are good because the money in the account can grow tax-deferred, and any future withdrawals are tax-free to you and your heirs.
Consider this example: Two fathers age of 65, both in the 28% tax bracket, each have $100,000 in their IRA account, and $28,000 in a separate taxable account. The first father uses the balance of the taxable account to convert his IRA to a Roth IRA. The other does not convert and keeps his funds in his SIMPLE account.
Over time, the first father’s Roth IRA account grows tax-free, and he does not take any RMDs. The father with the SIMPLE begins taking RMDs at age 70.
If both fathers die 20 years later, the children must begin taking their RMDs. The children who inherit the Roth account will have $1.8 million, assuming an annual rate of return of 8%. The children inheriting the SIMPLE will have $980,800.
Why is there such a significant difference in account values? The SIMPLE father and children will pay taxes on their RMDs. The father with the Roth IRA did not take any RMDs, and his children will be able to take withdrawals tax-free.
Talk to Your Beneficiaries
To ensure that your Roth IRA conversion earnings continue with your beneficiaries, prepare them and encourage them to be a part of the planning process now. If you want your heirs to stretch this tax-free shelter over their lifetimes, talk with them now about the rules they must follow after you die.
IRA account beneficiaries are subject to special distribution rules. Their first RMD is due December 31st of the year after the original account holder’s death, or by December 31st of the year the deceased would have reached the age of 70½ (whichever option is the latest). If the original account holder died after reaching 70½, the beneficiary must take his or her first RMD before December 31st of the year after the death.
Most laws for account beneficiaries tend to favor spouses, and they have more choices in the event that they inherit an IRA account. They can merge inherited traditional IRAs into their own Roth IRA account, whereas non-spousal beneficiaries cannot.
Non-spousal beneficiaries must set up an “inherited IRA” under the name of the original account holder. Multiple beneficiaries each need their own “inherited IRA” account so that each heir can base their RMDs on their own life expectancies; otherwise, their RMDs will be generated based on the life expectancy of the oldest beneficiary—which may cause a significant amount of the account value to be lost.
Also, before you convert, consider whether your tax bracket is higher than your child’s. For instance, if you’re in a 28% tax bracket, and your child is in a 10% tax bracket, it may not make sense to convert. However, most retirees are in a 0%, 15% or 25% tax bracket while their children are in a 33% tax bracket—in which case, a conversion would be beneficial.
Finally, if you decide to convert, use non-IRA funds to pay the income tax owed upon conversion to maximize IRA account value for tax-deferred earnings.
As of 2010, there are no longer income limits that prevent you from converting your traditional IRA to a Roth IRA, so now is the time to take advantage of this account and its growth potential.
Source: Kiplinger, by, Carlos Dias Jr.