Academic journal article Management Accounting Quarterly

Using Roth IRAs and Section 529 Plans as Estate-Planning Tools

Academic journal article Management Accounting Quarterly

Using Roth IRAs and Section 529 Plans as Estate-Planning Tools

Article excerpt

How can you use a traditional individual retirement account (IRA), a Roth IRA, and Section 529 plans for estate planning? Is one better than another? There are similarities between a traditional IRA and a Roth IRA. For example, contributions in both continue to grow tax-free until they are withdrawn during retirement or at age 59½ under current law-with some exceptions, such as catastrophic medical expenses. Likewise, owners of either type can pass them on to heirs.

Then what is the significant difference from an estateplanning perspective? The traditional IRA offers a tax deduction, which simply means that a taxpayer who contributes to the IRA receives a tax deduction for the tax year in which the contribution is made. On the other hand, the Roth IRA uses after-tax dollars, so no deduction is allowed from gross income when contributions are made. The distinct advantage of the Roth, however, is that none of the growth is taxed, and, assuming the age and/or other requirements in the tax law are met, the withdrawals are tax-free as well. There also are some different income limitations for the traditional IRA and Roth IRA. (For more information, visit

The pertinent issue here is what happens upon withdrawal. With a traditional IRA, the taxpayer will need to include some or all of the withdrawal amount in gross income since he or she received an upfront deduction for the year of contribu- tion. As a result, depending on their tax position and state tax statutes, the taxpayer or heirs may need to pay federal and/or state taxes as well. The taxes will depend on the state in which the contributor or heir is a resident when making the withdrawals.

With a Roth IRA, however, the taxpayer does not take a deduction on Form 1040 because the contributions are made with after-tax dollars. Again, the contributions continue to accrue interest tax-free, just like the traditional IRA, but qualified withdrawal amounts are not taxable. For a withdrawal to be tax-free, the owner must meet the following requirements: The owner must be age 59½, and the Roth IRA must have existed for at least five years.

A Roth IRA offers an advantage when retirement approaches. Unlike the traditional IRA, no minimum distribution rules apply to the Roth IRA, and the contributing taxpayer need not start taking distributions at age 70½. The taxpayer may choose to not access the Roth IRA at all and instead opt to leave it to heirs- again, also free of income tax.

A hypothetical example will help show the differences for those inheriting a traditional IRA vs. a Roth IRA. Then we will illustrate the difference in growth between the two and the tax advantages, as well as the benefits of a 529 Plan.

Inheriting a Roth IRA vs. a Traditional IRA

For our example, we will focus on Harry, Mary, and Carrie. Harry is married to Mary, and they have one daughter, Carrie. When Harry turned 65, he converted his traditional IRA into a Roth IRA and paid the taxes at the conversion time using other available funds. Thus he avoided a reduction in the value of his IRA, which would have occurred if he had paid the taxes from the traditional IRA. Harry named his wife as the beneficiary, lived 15 more years to age 80, and never made any withdrawals from his converted IRA. Because this is a Roth IRA, the account continues to accrue interest tax-free, and no minimum distribution rules apply as they would with a traditional IRA.

When Harry dies, his Roth IRA passes to his wife, Mary, who is 50 at the time of Harry's death. Mary treats the inherited Roth IRA as her own, retitling it in her own name, and does not need to take any minimum distributions because she has her own pension and other inherited assets.

Mary then designates her daughter, Carrie, as the beneficiary of her Roth IRA. Mary lives another 40 years, and, at the time of Mary's death, her daughter inherits the Roth IRA. When Mary dies, Carrie is 50, so, according to Internal Revenue Service (IRS) life expectancy tables, she should live another 30 years. …

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