ROTH IRA Always Worth It?
I’ve heard of – and believe in – the praises of ROTH IRAs. The ability to grow assets and (assuming all normal conditions are met) make distributions tax free is particularly alluring. But I get fuzzy on the tax benefit after death. I’ve always associated “ROTH” and “tax free” in my head but I’m not sure how that applies to state and federal income taxes, state and federal inheritance taxes, etc. for the heirs of ROTH vehicles.
Can anyone help shed light on this?
Thanks.
Permalink Submitted by Alan Spross on Wed, 2012-03-14 00:03
An inherited Roth IRA will be tax free to the beneficiary at both the federal and state levels as long as at least 5 years have passed since the Roth owners first Roth contribution. But a non spouse beneficiary must still take RMDs from the inherited Roth. These RMDs should tax free since taking RMDs would not reach the earnings in the Roth before the 5 years is attained, because the earnings come out last.
A Roth IRA is included in the gross estate of the owner, just like a traditional IRA. However, the taxes paid on a Roth conversion or to make the post tax Roth contribution will also contribute to the gross estate being somewhat lower. Large Roth conversions for wealthy elderly people are sometimes done to reduce their estate by the amount of taxes paid and thereby reduce estate tax. State estate or inheritance taxes vary too much from state to state to make general comment, although the prior observations also hold true.
Permalink Submitted by Amar Patel on Wed, 2012-03-14 18:33
I’m not sure I understand how the 2nd paragraph applies here, but I think I understand the 1st paragraph. The IRA would not be taxed to the beneficiary, nor the RMDs, if the 5 years has passed.
Thanks for the help!
Permalink Submitted by Alan Spross on Wed, 2012-03-14 20:09
The second paragraph addressed your question about state and federal inheritance taxes. The first paragraph addressed income taxes.
Permalink Submitted by Amar Patel on Sat, 2012-03-17 18:54
Hi Alan, thanks for that clarification. I am still not following along however. I think I understand the first paragraph, that RMDs taken by the beneficiary are free of income taxes. But I’m not clear about who is paying the estate taxes… the current owner or the beneficiary? Is it taken from the ROTH IRA or some other place?
Permalink Submitted by Alan Spross on Sat, 2012-03-17 22:22
Federal estate taxes are owed by the estate of the owner, and if a certain state also has a state estate tax this also applies.
An inheritance tax however is paid by the beneficiary receiving the funds. Any amounts due are not taken directly from an IRA or other account, but the govt entity may be able to put a lien on IRAs or other assets if amounts due are not paid from other funds. Many states do not have estate OR inheritance taxes, but some have estate taxes at a lower threshold than the federal, which currently only taxes decedents whose assets exceed 5 million. You will have to check with the appropriate state tax authority for state requirements.
Permalink Submitted by Steve Mayer on Sun, 2012-03-18 03:47
If you ,or anyone else who contributes or reads this forum, makes approximately the same lifetime contributions, to a life insurance policy, in addition to, or instead of [url]http://www.401klifeinsurance.com[/url%5Da Roth IRA,it can be lifetime tax free income, and what you leave your estate will be considerably larger and also tax free.
Permalink Submitted by Peter Lingane on Sun, 2012-03-18 16:45
The income taxation of life insurance and Roth IRAs is similar: contributions are made with after tax dollars and there is generally no income tax on distributions. The difference is that fees are generally higher with life insurance. I say generally because some invest their Roth IRAs in life insurance products (annuities) and others pay substantial management fees.
The risked value of a Roth IRA is the sum of the values at future ages weighted by the risk of death at each age. The risked value of life insurance is the death benefit. The risked value of a Roth IRA is generally larger than the death benefit because of the higher fees associated with life insurance.
The risked value of a Roth IRA involves market risk while the death benefit is guaranteed, subject to the creditworthiness of the insurance company.
Roth IRAs are subject to federal estate tax while it is possible to arrange for life insurance to be exempt from estate tax. This difference only matters for large estates.
Current law allows Roth IRAs to be “stretched” out over the lives of the heirs whereas life insurance cannot. The net present value of this benefit is large and can exceed any federal estate tax.
If there are no distributions from a Roth IRA or life insurance during life, the after tax amount that passes to the heirs should be larger with a Roth IRA unless death is premature, markets are unkind or the Roth estate is large enough to attract federal estate tax. The value that passes to the heirs should be considerably larger with a Roth IRA if markets are kind and/or the heirs take gradual distributions over their lifetimes.
I presume that meyerpensionmax knows that it is misleading to say that “what you leave your estate will be considerably larger” with life insurance. The site administrator should remove the previous post.
Permalink Submitted by Bruce Steiner on Sun, 2012-03-18 21:08
While he does so in a misleading way (the site administrator should look not only at his post in this thread, but at all of his posts), meyerpensionmax alludes to an interesting point regardung the estate tax.
Life insurance is not exempt from estate tax, but you can give it away and thereby get it out of your estate. That’s not unique to life insurance. You could give away cash and the donee could invest it in assets other than life insurance. If you die substantially before life expectancy, your family will come out ahead if they invested in life insurance. Depending on when you die and how well the other assets perform, your family will probably come out ahead by investing in other assets if you live close to, to, or beyond your life expectancy.
However, you can’t give away an IRA during your lifetime. That creates a tension if you’ve already given away all of your non-IRA assets, and you want to continue making annual gifts. That’s less likely to occur if the estate tax exempt amount settles at $3.5 million or higher, but is more likely to occur if it reverts to $1 million. In that case, you have to choose between maximizing the income tax deferral of the IRA or taking some distributions in excess of living expenses (or perhaps some distributions in excess of the required distributions in the case of a traditional IRA) to fund the annual gifts. I haven’t analyzed this in many years (the issue arose more often before 2002 when the estate tax exempt amount was $675,000 or less), but I think the estate tax benefit of the annual exclusion gifts outweighed the income tax benefit of maximizing the income tax deferral of the IRA, at least as to the annual exclusion gifts.