How and Why to Use Roth IRAs in Estate Planning

Roth Contributions

For clients eligible to do so, contributing to a Roth IRA each year can help build a Roth balance to pass on to beneficiaries. For those who have access to a Roth 401(k) account via an employer-sponsored plan or a solo 401(k) for the self-employed, contributing to a Roth 401(k) can offer a higher contribution limit with no income restrictions as with a Roth IRA. The amount in the Roth 401(k) can later be rolled over to a Roth IRA with no tax consequences, avoiding RMDs as well. 

Roth IRA Conversions 

A Roth IRA conversion is a strategy to consider for passing IRA assets to non-spousal beneficiaries either directly or as contingent beneficiaries upon the death of a surviving spouse. This is a viable way for a client to prepay taxes for their beneficiaries. 

Beyond prepaying the taxes, the five-year rule can come into play if your client did not previously have a Roth IRA. 

Whether or not a Roth IRA conversion makes sense as an estate planning tool depends on a number of variables, including: 

The client's current tax situation. If they are in a high tax bracket, the amount due in taxes on the conversion may not be worth the ultimate tax benefits to the non-spousal beneficiaries. If the client is in a relatively low tax bracket, this can be more beneficial. This situation might be the case if your client has recently retired and is not yet taking their Social Security benefit.

Your client is relatively young. This might be someone in their 40s or 50s. This situation provides them with a potentially long time horizon for the converted amounts to appreciate in value and offset much of the impact of the taxes on the conversion.

In looking at the taxes that would be incurred by your client on the conversion, it is important to weigh this against the estimated tax savings in the future from not having to pay taxes on the RMDs for the amounts converted. 

Whether or not a Roth IRA conversion is both beneficial and desirable as an estate planning strategy can vary from year to year based on your client's tax situation and that of the overall family. 

Backdoor and Mega Backdoor Roths

These two strategies have been in, out and in again (at least currently) as part of the Democrats' tax and spending bill. The latest version of this proposed legislation has included the provisions that would eliminate the conversion of after-tax amounts in an IRA or retirement plan such as a 401(k) by the end of 2021. At this point it is hard to be sure what the final version of the bill will look like with regard to these strategies. 

If your client has a mega backdoor Roth via their employer's 401(k), you should at the very least look at the options for this money if this is prohibited in the final bill. If a backdoor Roth makes sense for a client, you will want to be sure to get this done prior to Dec. 31 of this year. 

Roth IRAs have many potential benefits as a planning tool for your clients. With the advent of the Secure Act and the evolving tax and estate landscape, a Roth IRA can play a key role in your client's estate planning efforts under the right circumstances.