Last week, I went over the major advantages and differences among the various types of Individual Retirement Accounts (IRAs) available to investors. But today I want to dig a little deeper into one particular aspect of Roth IRAs that makes them really attractive to anyone planning on leaving money to an heir.
It all starts with something I said in my last column — namely, that unlike their traditional brethren, Roth IRAs do not require you to EVER begin taking minimum distributions. In fact, as long as you keep earning income (or alimony) you can continue contributing.
What that means is that you can leave every single penny of your Roth IRA intact for your designated beneficiary. That alone is a huge plus!
Even better is the fact that your heir will face a choice upon your death: Either withdraw the whole amount by December 31 of the fifth year after your death OR begin receiving minimum distributions based on his or her life expectancy.
Under either choice, all the proceeds should be tax-free (with the exception of estate taxes).
Here’s an example:
Say you leave your Roth IRA to your son who is 53 at the time of your death.
If your son decides to take minimum distributions, the IRS will use its actuarial tables (available in IRS pub. 590) to figure out roughly how long your son is likely to live.
Then the IRS will divide the value of your account by that number (31.4 in 2011) to arrive at a dollar amount for yearly distribution.
In the case of a $100,000 portfolio, your son would have to withdraw $3,289 in 2012 ($100,000/30.4).
Important: While your son is taking those minimum distributions, the value of his inherited investment account can continue to rise!
I’m sure you can see the appeal of this approach, especially since you’re well aware of the effect of compounding.
Think about what would happen if you loaded up that Roth IRA with stocks that steadily increase their dividends. And imagine what would happen if you were reinvesting those dividends back into more shares!
You’d be combining complete tax efficiency with multiple layers of compounding interest. Heck, with enough time, you could leave behind a nest egg that was rising FASTER than the rate of your heir’s mandatory withdrawals!
That brings me to another point. While this strategy would be great for a son or daughter, it would be even better for a grandchild or a great-grandchild.
After all, those minimum distributions are calculated on the recipient’s age. The lower the number, the less money coming out every year and thus the longer the account can grow.
Obviously, the lynchpin in this whole plan is absolute agreement on the part of the original account owner and the beneficiary on opting for taking the minimum distribution route.
But if you have an heir you can count on, I consider this one of the smartest moves you can possibly make.
If you’re eligible for a Roth IRA, take advantage. And even if most of your money is currently in a regular IRA account, it may very well be worth your while to roll it into a Roth if this particular wealth transfer strategy appeals to you.
Although you’ll take a big tax hit in the process, if your goal is leaving that money to someone far younger, the Roth could still prove the smarter wealth builder over the long haul. That’s definitely something to be thankful for!
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