Roth Taxation and DeferraL

While traditional IRAs offer a considerable tax deferral and deduction, you must pay tax at regular income tax rates on the withdrawals that must begin no later than April 1 of the year following the year the participant turns 70 1/2.

What makes the Roth IRA so powerful is that minimum distribution rules do not apply after the participant reaches age 70 ½. There are no required minimum distributions until after the death of the participant. If he or she lives until age 85, there will have been an additional 14 to 15 years of tax deferral to that point. There is also the potential of 15 more years of continuing contributions, if there is earned income during that period.

Ignoring the possibility of a spousal beneficiary (or spousal rollover) for the moment, let us assume that the required minimum distributions start now for the year following the participant’s death.

Those distributions will be payable to the participant’s beneficiary using a single life term certain method. Let us assume that beneficiary is a child 25 years younger than the participant is. The beneficiary would now receive tax-free distributions over a 24-year period (based on a single life expectancy of 23.3, being decreased by one each year). Even if the beneficiary died during that period, the distributions need not be accelerated. They could continue tax free to the recipient for the full 24 years!

The after-death tax-free growth component can be an important issue in a Roth analysis. In some cases, this future tax-free growth arguably makes the Roth IRA more valuable than the ordinary IRA, even the day after you convert.

For example, let us assume a death at age 50 with a child as the beneficiary who is 25 years younger. That 25-year-old would have a life expectancy of 57 years. If he were not to withdraw the Roth IRA any faster than required, he would withdraw 1/56 of the balance when 26 years old, 1/55 of the balance when 27 years old, etc. During all that time, the IRA balance would grow tax-free and distributions would be tax free to the child. If the funds had been left in a traditional IRA, the same deferral period would apply. However, all the growth would be taxable as distributions are made. If both IRAs have the same starting balances, the value of the after-death growth in the Roth IRA will be much higher than in the traditional IRA.

Thus, if estate planning for future generations is a primary concern, a Roth IRA conversion may be an attractive option that reduces the taxable estate (through incurring immediate income tax), yet ultimately may provide more net benefit to the beneficiaries.