When used optimally, the Roth IRA offers some extraordinary benefits. Many people, however, aren’t maximizing the financial advantages, which can last for generations.
The way to get the most advantage from a Roth is to extend its tax-free life as long as possible.
During your lifetime, plan to use assets in a Roth last to fund your later-in-life goals. Spend down taxable and tax-deferred retirement accounts first and leave your highest growth assets (largest expected return) in the Roth to compound bigger untaxed gains over time.
A Roth IRA’s greatest achievement may then come after your lifetime. If you practice proactive planning for your family’s long-term financial security, this is where you should consider naming someone other than your spouse as beneficiary. If the spouse is expected to have enough income from other sources, the Roth IRA may be better inherited by a child or even a grandchild. This is the best leverage of the tax code and could make a monumental difference in the amount of money ultimately paid out of the Roth.
When an IRA is inherited by a nonspouse beneficiary – and it is not liquidated – it becomes subject to annual required minimum distributions. In the case of the Roth, these distributions remain tax free, just the way they would have been for the original owner. The beneficiary will have to withdraw a little bit of the account value each year based on the IRS uniform life expectancy table.
The younger the beneficiary, the lower the annual withdrawal requirement and therefore the larger the account left to take advantage of growth over time.
Over an extra generation, quadruple the amount of money could be distributed from the account.
A MAGICAL EXAMPLE
Jim Goodplanner dies in 2012. He has $10,000 in a Roth IRA that will not make a big difference in the financial security of his wife. If the named beneficiary were instead a child of Jim’s – age 50 for the sake of this example – the required minimum distributions would start the year after Jim’s death. If the beneficiary lives until 95 (the IRS life expectancy table actually runs through 111) the required minimum withdrawals would equal $45,858 and there would be $3,357 left in the account. This assumes a 7 percent average annual investment return.
Alternatively, consider the power of compounded growth spread over another generation. If Jim named his 20-year-old grandchild as beneficiary, the longer life expectancy would require a first-year withdrawal of only $159. Over the next 75 years, assuming required withdrawals until death at 95, the grandchild would withdraw $199,200 – tax free – 335 percent more dollars withdrawn from the same original $10,000. And the account would still have a balance of $13,420. This is all without making any contributions to the account.
BENEFICIARY BENEFITS
Beneficiary planning is important. It’s something you should review even if extending the benefit of an IRA as far as possible is not your primary objective. If, however, stretching the IRA is a wise option and it is overlooked by the account holder, a spouse can disclaim the inheritance of an asset like a Roth potentially shifting its transfer to a beneficiary with a longer life expectancy. The succeeding beneficiary would be any other named primary or contingent beneficiary. This is a good reason to name more than just one beneficiary on your account.
Of course, many accounts have multiple beneficiaries. If this is the case, it is best to split the original account into individual inherited IRA accounts. This is the only way to preserve the life expectancy withdrawal calculation for each beneficiary. If the account is not separated by beneficiary, the required distributions will be based on the oldest beneficiary.
GETTING MORE MONEY INTO A ROTH
The income limit for funding a Roth IRA in 2012 is $169,000 (Modified Adjusted Gross Income) for married filing jointly taxpayers and $107,000 for single payers. The contribution limit is $5,000 for people 49 and under and $6,000 for 50 and over.
If you’re over the income limits to contribute directly you can still use a backdoor route to get dollars into a Roth. It involves first making a nondeductible, after-tax contribution to a Traditional IRA and then converting those contributions to a Roth IRA.
You can also convert current pre-tax dollars to after-tax Roth status. While there is no current income limit to this option, it only makes sense in a relatively limited number of situations.
Of course, there are many details that could affect your taxes and your investment strategy so you should be careful to fully understand the pros and cons before proceeding.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at gary@bhjadvisors.com or read his blog at www.themoneyarchitects.com.
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