Stop the Clock: Roth IRAs and Legacy Planning
by Trey Finch
Legacy planning is about transferring wealth to your loved ones as efficiently as possible. This is primarily accomplished through an effective tax strategy, and one of the most powerful vehicles for lasting wealth is a Roth IRA.
This type of retirement account can create generational income for the account holder and their loved ones. Additionally, it is frequently a much more efficient means of wealth transfer than a traditional IRA or 401(k).
But, does it make sense for your legacy plan to include a Roth IRA? As a Certified Financial Planner in Brentwood, TN, here’s what you need to know about Roth IRAs and how they can impact legacy planning.
Join us in exploring these topics:
- What is a Roth IRA?
- What is legacy planning?
- How do Roth IRAs & legacy planning work together?
- Tax Benefits for Your Heirs
What is a Roth IRA?
In the simplest terms, a Roth IRA is a tax-advantaged account designed to help you save for retirement. It allows you to contribute after-tax dollars, which will grow tax-free, and be withdrawn (also tax-free) after the age of 59 ½. You pay taxes on the money going into your Roth IRA, but all gains and future withdrawals are tax-free.
With a traditional IRA or 401(k), on the other hand, you contribute pre-tax dollars but future withdrawals are taxed at your then-current income tax rate. Typically, investors choose to use a Roth IRA over a traditional IRA when they believe their marginal taxes will be higher in retirement than they are now.
There are several restrictions on who can contribute to a Roth IRA. Primarily, any single filer earning more than $144,000 or a married couple earning more than $214,000 cannot utilize a Roth IRA. However, if your income is below the limits, you can contribute up to $6,000 to your Roth IRA. If you are over 50 years of age, this number includes a $1,000 catch-up provision to bring the total to $7,000.
It should be noted: If your income is higher than the above limits, you can still utilize a Roth IRA by means of a “backdoor” Roth conversion. We have more about Roth conversions and retirement planning here.
What is Legacy Planning?
Preparing for the transfer of your assets to your heirs is what wealth managers mean by “legacy planning.” Similar to estate planning, its primary purpose is to develop a strategy that accomplishes your goals in the most tax-efficient manner. In addition to your physical property, you may also choose to include some abstract elements into your legacy plan, such as your core values or an emphasis on charitable giving.
Fundamentally, legacy planning is a process that allows you to be intentional with the estate you leave behind to your loved ones. Unfortunately, there is a complex set of tax laws to deal with. That is why many people choose to work with financial advisors or other tax professionals to help them develop their plans in keeping with IRS regulations.
How Do Roth IRAs & Legacy Planning Work Together?
Roth IRAs offer tax-free distributions (meaning withdrawals) in retirement. In addition to being great tax-saving tools, they also provide exceptional legacy planning advantages. This is especially true if you have a large portion of your wealth in your Roth accounts. Ask us about Roth conversions or read How Roth Conversions Affect Retirement SavingsThe primary reason for using Roth IRAs is the 0% tax rate. But if you don’t need the money for retirement or don’t plan to spend it all, there’s another huge advantage to this account type: Wealth transfers.
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Tax Benefits for Your Heirs
Roth IRAs still involve paying the federal estate tax (affecting estates of greater than $11.7 million for individuals and $23.4 million for married filers). At the same time, they are exempt from all future income tax bills. This includes both your own and those of your heirs.
When you contribute after-tax dollars to your Roth IRA, there will be no additional income taxes paid on those funds or any gains generated by those funds.
No Required Minimum Distributions (RMDs)
A required minimum distribution (RMD) is the smallest amount of money that can be withdrawn from a traditional IRA or 401(k) plan each year (once the account holder reaches age 72). Since contributions to these accounts are pre-tax dollars, required withdrawals are taxed at the account holder’s then-current income tax rate.
When you don’t need the money, RMDs can create frustrating tax bills. Thankfully, Roth IRAs are exempt from RMDs for the account holder: You can leave the balance as-is, accumulating as much non-taxable savings as possible–in order to pass that along to your heirs.
However, the RMD exemption expires when you die. At that point, the Roth IRA will fall under rules that impact all inherited IRAs (and include required minimum distributions). However, if your heirs can discipline themselves, the account liquidation process can last for many years. For more information on Roth IRAs and estate taxes, read this article from Investopedia.
An Example of a Legacy Plan With a Roth IRA
To illustrate and tie this all together, let’s assume that Bob passes away at 75 years old. He has a Roth IRA and his wife, Sally, is 70 years old when he dies. Sally inherits the Roth IRA as the account’s designated beneficiary.
The IRS has a single life expectancy table–and according to it, she can expect to live another 17 years. As the spouse to the account holder, Sally can use the inherited Roth as if it were her own. Therefore, she is not required to take any RMDs. At age 87, Sally passes away and leaves the account to the couple’s son, Rick, who gets designated as the new beneficiary.
Thanks to the diligence of his parents, Rick was able to enjoy a federal-income-tax-free annuity which he used to pay for his kids’ education. That was always important to Bob and Sally, as well.
Your Financial Possibilities
Legacy planning is rapidly growing in popularity. It gives you the opportunity to make a difference in the lives of your heirs and other causes that you may care about. It is also an excellent way to limit the amount of taxes your estate will pay—because incorporating a Roth IRA into your strategy can help create a lasting legacy.
However, before you attempt this strategy by yourself, you may want to seek professional advice from a financial planner or tax advisor on tax and legacy planning considerations. A quality wealth manager will include legacy planning in your comprehensive planning. If you don’t have a financial advisor or you want to learn more about our holistic financial services, schedule an appointment with TrustCore today.
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