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Leave Your Kids a Tax-Free Legacy

Posted Thu Nov 5, 15:59 pm ET

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EDITOR'S NOTE: This article was originally published in the September 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.

 

Let's say you have a traditional IRA, and you'd like to leave all or most of it to your kids or grandchildren. Consider converting the retirement plan to a Roth IRA.

Rolling a traditional IRA into a Roth IRA is treated as a taxable distribution, so you will pay income tax in the year you convert. The assets will continue to grow, and your offspring will be able to take tax-free distributions for the rest of their lives. "Once Dad pays tax on the seed, the harvest for the children and grandchildren is tax-free," says James Lange, author of Retire Secure!: Pay Taxes Later (Wiley, $25).

To show the potential of the Roth conversion strategy for estate-planning purposes, Lange offers this illustration. Two 65-year-old fathers in the 28% tax bracket have traditional IRAs, each containing $100,000. Each parent also has $28,000 in a taxable account. 

One father converts his traditional IRA to a Roth IRA, using his $28,000 to pay the tax. The other father doesn't convert. The Roth parent doesn't have to take required minimum distributions, and he lets the entire account grow tax-free. The traditional father must take RMDs starting at age 70. They both live 20 years and leave their IRAs to their children, who are the same age. 

After the parents die, each child must take RMDs. Thirty years after the parents' deaths, the Roth child has $1.8 million in future dollars, assuming an 8% annual rate of return. Meanwhile, the traditional child has only $980,800. Why the difference? The traditional parent and child paid taxes on an RMD every year for 50 years. Meanwhile, the Roth parent took no distributions, and the Roth child took annual RMDs tax-free.

A conversion could also eliminate or lower federal and state estate taxes, says Natalie Choate, estate-planning lawyer at Nutter McClennen & Fish, in Boston. Say you're in the 33% tax bracket and your $4 million estate includes a $2 million IRA. If you convert the IRA, paying about $650,000 in federal income taxes will drop your estate below the $3.5 million federal estate-tax exemption.

Robert Miller, 80, who lives in Penn Hills, Pa., has made a series of conversions to a Roth IRA over the years. Miller, a retired engineer, plans to convert another chunk this year. Rather than selling investments in his traditional IRA and moving the cash to the Roth, Miller will simply transfer shares of stock from one IRA to the other. Because the market value is depressed, Miller can transfer a larger number of shares. Once the market rebounds, those shares will appreciate in the Roth IRA tax-free—a boon to his three children. "Taxes will go up, so this is one way to ease the burden for them," he says.

Heirs Must Follow Rules

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. Although a widow or widower can roll an inherited IRA into his or her own Roth, other beneficiaries cannot.

Instead, a non-spouse heir must set up an "inherited IRA," and the name of the deceased must remain on the account. Lange suggests language something like: "Inherited IRA of Joe Sr. for the benefit of Joe Jr." The money must be transferred directly into the new IRA.

If you have several beneficiaries, they should split the account into separate inherited IRAs. If they don't split the IRA by December 31 of the year after your death, their RMDs will be based on the life expectancy of the oldest beneficiary—yielding larger distributions and depleting the account more rapidly. By splitting, heirs can each use his or her own life expectancy.

A few cautions: This year, you cannot convert to a Roth IRA if your adjusted gross income exceeds $100,000. That income limit disappears in 2010. Also, it's best to pay the income tax on the conversion with non-IRA money so you preserve the account's growth potential. And it may not make sense to convert if you're in a high tax bracket and your kids are in a lower one.

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