Estate Planner May-June 2007
Roth IRAs can offer significant estate planning advantages over traditional IRAs. But until recently, these advantages have been unavailable to higher-income taxpayers who often stand to benefit the most. Under tax legislation passed last year, anyone – regardless of income level – can convert a traditional IRA to a Roth IRA starting in 2010.
Know the difference
Traditional IRAs can offer current tax deductions and tax-deferred growth, but withdrawals are subject to ordinary income taxes at rates as high as 35%. A Roth IRA takes the opposite approach: Contributions aren’t deductible, but qualified withdrawals of contributions and – best of all – earnings are income-tax free.
From an estate planning perspective, the Roth IRA is the clear winner. With a traditional IRA, you have to take required minimum distributions starting at age 70 1/2, whether you need the money or not. But a Roth IRA can continue growing income-tax free indefinitely, allowing you to build a larger nest egg for your family.
Also, when you leave a traditional IRA to your children or other heirs, income taxes may take a big bite out of their inheritance because they’ll have to pay income tax on all distributions. Roth IRAs provide a dual estate planning benefit: Not only are distributions to your heirs income-tax free, but the amounts you pay in taxes on the income you contribute to the Roth IRA are removed from your estate. In other words, by paying the taxes associated with a Roth IRA, you essentially make a tax-free gift to your heirs.
Know your limits
There’s no income limit for making contributions to a traditional IRA. So long as you receive enough compensation from a job to cover your contribution, you can set aside up to $4,000 in 2007 ($5,000 if you’re 50 or older). If you’re married and your spouse has little or no income, you may also be able to contribute similar amounts to a spousal IRA.
The tax deductibility of your contributions, however, depends on your participation status in employer-provided retirement plans and your income. If, for example, one or both of you participate in a plan at work, your IRA contributions become nondeductible above specified income limits, which are quite low.
Roth IRAs are subject to the same contribution limits as traditional IRAs, but higher-income taxpayers are ineligible. If you’re a joint filer, for example, your ability to contribute to a Roth IRA in 2007 is phased out beginning at $156,000 of modified adjusted gross income (MAGI) and eliminated once your MAGI reaches $166,000. If you’re single, the phaseout range is $99,000 to $114,000 of MAGI.
It’s also possible to convert an existing traditional IRA into a Roth IRA. Previously, this option was reserved for taxpayers with MAGI of $100,000 or less. But the income limit for conversions will be eliminated – beginning in 2010 – under the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which was signed into law in May 2006. This is good news if you’ve built up large balances in traditional IRAs, either through annual contributions or by rolling over funds from a 401(k) or other employer-sponsored retirement plans.
Know your options
TIPRA opens the door for higher-income taxpayers to take advantage of the Roth IRA’s estate planning benefits. By converting a traditional IRA into a Roth, you can avoid required minimum distributions and allow your savings to continue growing income-tax free.
You’ll have to pay income tax on the amount you convert, but in many cases the benefits of tax-free growth outweigh the tax hit. Plus, if you make the conversion in 2010, TIPRA allows you to defer the tax and include half of the conversion income on your 2011 return and half on your 2012 return.
Be sure to analyze the tax consequences before you convert. Depending on the size of your IRA and your income level, a Roth IRA conversion can bump you into a higher tax bracket. If that’s the case, you may want to convert your IRA gradually over several years to minimize the tax impact.
TIPRA doesn’t lift the income restrictions on contributions to a Roth IRA. But it creates a “back door” option for high-income earners.
For example, Nancy, age 50, doesn’t have an IRA. With MAGI in excess of $200,000, she’s ineligible to contribute to a Roth IRA but can make nondeductible contributions to a traditional IRA. Nancy sets up a traditional IRA in 2007 and contributes $5,000 per year. Assuming an 8% rate of return, the IRA’s balance in 2010 is $22,531. Nancy converts the entire amount into a Roth IRA. Because her contributions (totaling $20,000) weren’t deductible, Nancy pays taxes only on $2,531 in earnings. She can include the entire amount on her 2010 return, or report half that amount on her 2011 and 2012 returns.
After 2010, Nancy continues contributing $5,000 per year to her traditional IRA, avoiding taxes on the earnings by immediately converting the funds to her Roth IRA. When she retires at age 65 (again, assuming an 8% rate of return), her Roth IRA has grown to more than $150,000, all of which can be distributed income-tax free.
Assuming that the law isn’t changed, the new conversion rule effectively allows Nancy to enjoy the benefits of a Roth IRA even though she’s ineligible to make Roth IRA contributions.
Making the switch
Under the right circumstances, the new conversion rules create valuable estate planning opportunities for high-income earners. Be sure to check with your tax advisor before opening a Roth IRA account.