Roth IRAs Are Not Just for the Young

Most financial advisors recognize that Roth IRAs are an ideal investment vehicle for young people, but fail to realize that they can be useful for seniors, too.

Income taxes are paid up-front on funds invested in Roth IRAs, then the funds grow tax-free throughout the owner's lifetime and are distributed tax-free, assuming regulations for qualified distributions are followed. As a result, the longer money stays invested in a Roth IRA, the greater the tax-free income the owner can accumulate.

This feature makes the Roth IRA an ideal estate-planning tool, since seniors in many cases can pass Roth assets on to their heirs virtually income-tax-free. Over time, because of tax-free compounding, even a relatively small inheritance of Roth assets can grow into millions of dollars.

Owners of traditional IRAs and qualified retirement plans must begin taking minimum distributions at age 70½. Owners of Roth IRAs are never required to take distributions, so they can pass all of their Roth assets on to heirs, who can take distributions without paying income taxes. Roth assets may be subject to estate taxes, but, with proper planning, estate taxes can be reduced or even avoided.

The value of using Roth IRAs to pass assets to heirs is best shown by example. Assume a 65-year-old widow has $100,000 in a Roth account earning 10% a year and a 35-year-old son is the beneficiary. When the widow dies at age 87, the Roth assets will total $814,027. The law gives her 57-year-old son two alternatives - he can begin taking distributions within a year of his mother's death or he can leave the assets untouched for up to five years, after which he would have to withdraw them in a lump sum.

He determines that it is financially advantageous to take distributions throughout his lifetime. Based on his life expectancy, which is 84 at the time, his first-year distribution is $30,149. The amount will grow each year, based on his changing life expectancy and the value of the underlying assets. By age 83, the assets distributed tax-free will total nearly $4.3 million - all from the initial $100,000 Roth IRA.

The results of this hypothetical example are even more impressive if Roth assets are left to a four-year-old granddaughter. She could receive distributions exceeding $43 million by the time she is 83.

Other Advantages
Roth IRAs also have administrative advantages. For example, Roth assets can be passed on to heirs without going through probate. Assets will automatically be left to the individual named on your Roth IRA beneficiary form.

Roth IRAs can also help avoid potential distribution problems. If a spouse dies before the owner of a traditional IRA, money in the account typically is distributed by the end of the year after the owner's death, because penalties accrue unless the distribution is timely. After the distribution, income taxes are due on the entire amount. Conversely, Roth IRA accounts can be set up so that assets are automatically distributed to children after the death of the second spouse, and no income taxes are due.

Establishing Roth IRA Accounts
Seniors are most likely to accumulate Roth IRA assets by converting traditional IRAs to Roth IRAs. They can also convert assets from pension plans into traditional IRAs, then convert those IRAs to Roth IRAs. Owners of traditional IRAs can convert them to Roth IRAs at any time, as long as their adjusted gross income (AGI) for the year, whether filing individually or jointly, does not exceed $100,000. One disadvantage is that converted funds are subject to income taxes during the year of the conversion. If you cannot afford to pay the taxes using non-Roth IRA funds, consider a partial conversion.

In addition, working seniors can contribute up to $2,000 a year ($4,000 for a married couple) to a Roth IRA account, as long as they earn at least that amount. AGI cannot exceed $95,000 for a single taxpayer or $150,000 for married taxpayers filing jointly. The law allows partial contributions for individuals earning $95,000 to $110,000, and for couples earning $150,000 to $160,000.

While the Roth IRA can be a powerful estate planning tool, it is not ideal for everyone. In fact, some seniors may end up paying more taxes with a Roth IRA than with a traditional IRA. In some cases, taxes paid as the result of a conversion can result in a lower inheritance than if the assets remained in a traditional IRA. Seniors who are already taking retirement distributions could find that a Roth conversion would accelerate their income taxes. In most cases, though, Roth IRAs are as well suited for seniors as they are for young people.

By Darrell J. Canby, CPA, CFP®

Darrell J. Canby, CPA, CFP® is a founding shareholder of Canby Maloney & Company and President of Canby Financial Advisors, LLP, both of Framingham, Mass.