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A Clever Way to Cut Your Heirs' Income Taxes

By Wendy Connick – Sep 14, 2017 at 7:31AM

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Want to reduce your beneficiary's tax burden? Consider the estate planning power of a Roth IRA.

While there's no telling what will happen once tax reform finally takes effect, for now, taxes are a major concern for those who are doing estate planning to pass on their assets to their loved ones. If you don't want to have large portions of the money you leave your heirs gobbled up by income taxes, you'll need to find a way to convert that money to a nontaxable form.

Enter the Roth account

The money that you put into a Roth retirement savings account has already been taxed, whether it got there via contributions you made or as a rollover from a tax-deferred retirement savings account. Thus, everything in that account is now considered nontaxable for income-tax purposes. As long as the Roth has been open for at least five years prior to your death, the money in that account is immune from federal income taxes.

If you leave the money in your Roth account instead of spending it during your retirement, then after your death the account will go to the person you designated as a beneficiary. Once that happens, the account will be subject to the IRS's rules for inherited IRAs. The beneficiary will be required to start taking distributions based on their predicted lifespan (the IRS provides actuarial tables to use for calculating this required minimum distribution). Assuming that your beneficiary doesn't just empty out the account, the balance left in the Roth account will continue to grow tax-free, providing a bounty of untaxed income for years to come.

Nothing is certain but death and taxes

Image source: Getty Images.

Using Roth accounts for estate planning

This estate planning approach only works if you don't spend the money in the Roth account yourself. Thus, it's important to plan ahead and find other sources of income to finance your retirement, while leaving the Roth account for your heirs. If you didn't set up a Roth account for yourself before you retired, don't panic – you can do a Roth conversion at any age.

For example, retiree Rob is 70 years old and has decided that it's time to do some estate planning. He sits down with his tax and investment advisors, adds up his retirement savings and other sources of income, and decides that he wants to set aside $200,000 for his beneficiaries to enjoy after he's gone. Rob's tax advisor warns him that doing a Roth conversion will result in a significant tax bill, so Rob decides to stretch out the conversion over five years, moving $40,000 each year from his traditional IRA to his Roth IRA. Each year he pays $5,067.50 in taxes to the IRS for the privilege of converting the money over (Rob is married and files a joint return with his wife, so he uses the married filing jointly tax brackets). As a bonus, the taxes that he pays to do the conversion will shrink his estate, making it less likely he'll need to pay estate taxes on it. Thus, the $5,067.50 is like an untaxed gift to his beneficiary -- one that doesn't count toward the gift tax exemption.

After Rob's death, the Roth account goes to his son Bob, who starts taking distributions according to the IRS's required minimum schedule. Rob has now given Bob what amounts to an income-tax-free annuity by using the Roth as a vehicle for his bequest. Now there's a legacy that Rob can be happy to leave behind.


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