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The
Value of a Roth in an Estate
by:
James Lange, CPA, JD and
Steven T. Kohman, CPA, CEP
With the advent of the Roth IRA,
financial and estate planners have been given a new tool to optimize
retirement and estate plans for individuals with significant assets
in their retirement plans.
A Roth IRA has the potential to provide a great source of
wealth for your clients and their heirs. This article will quantify
the exceptional value a Roth IRA has as part of an estate.
An in-depth analysis of the merits
of converting a regular IRA to a Roth IRA is beyond the scope of
this article.1 However, we do believe that, for individuals who qualify,
it is definitely worth considering a Roth IRA conversion. Jim Lange's
peer reviewed article IRAs
After the TRA ‘97—What Hath Congress Roth? provides
conclusive evidence that the benefits of a Roth IRA conversion extend
to both the owner during his/her lifetime and to his/her heirs.
This article focuses on quantifying the benefit to the heirs.
For the purposes of this article,
we compare and contrast the estates of two individuals:
-
One
individual elects to convert $100,000 of his IRA into a Roth
IRA. We assume that the client will preserve the Roth IRA investment
with its tax-free status and no minimum distribution requirements,
and spend other assets first to provide for his/her retirement.
As such, when the time comes to distribute this estate, the
Roth IRA owner continues to have significant holdings in his
Roth IRA, and fewer assets in other after-tax investments.
-
The
second individual elects to retain his conventional IRA (the
no conversion scenario). If the client lives long enough, the
IRA is substantially diminished due to the minimum distribution
requirements. When the time comes to distribute this estate,
we assume that the IRA holdings are substantially reduced but
that the owner still has significant assets in after-tax investments,
such as cash, stocks, bonds, mutual funds, CDs, and savings
accounts.
The “Hidden”
Value of a Roth
To quantify the advantages of a conversion,
it is necessary to "run the numbers" to see how our clients'
money will grow and be used throughout their lifetime. We do this
by comparing the projected outcomes from our two scenarios—converting
$100,000 of the IRA to a Roth IRA versus maintaining the status
quo or not converting the IRA. In most cases, using reasonable assumptions, it is clear that
the Roth IRA conversion will generate substantial additional wealth
for the owner and their surviving spouse during his/her lifetime.2 Occasionally the projections for both scenarios do not
seem appreciably different. That is to say, at the end of the client's
and their spouse's life expectancies, the two estates contain roughly
the same value of assets measured in immediate purchasing power.
However, simply comparing the total number of
dollars available to each estate at the time of the client's death
is not a very sophisticated analysis.
Too frequently the estate planning stops here and the client
makes the inappropriate decision not
to convert to a Roth IRA. This
estate planning decision may result in the loss of a valuable opportunity.
To fully appreciate the merits of inheriting a Roth IRA, we need
to project the analysis over a much longer time scale.
Let's assume we have run the numbers and the
two estate projections contain the same purchasing power measured
as if all the money were to be spent the day after death.
Measured in immediate purchasing power, the estate containing
the Roth IRA has no advantages over the estate comprised primarily
of after-tax investments. An after-tax dollar in your pocket will
buy the same cup of coffee as the dollar in your pocket from a Roth
IRA. The same holds true for
your client's heirs upon inheritance of those assets.3
On the face of it, the two projections seem equal. If your client's
heirs intend to immediately liquidate their inheritance for reasons such as debt
retirement or for spending purposes, there are no advantages to
inheriting a Roth IRA over after-tax investments. However, if your
client's heirs maintain the investment and take only the minimum
required distributions through their lifetime, then your client's
Roth IRA conversion will provide his heirs with a monumental benefit.
The inherited Roth IRA has a “hidden” value
in the estate. The value of an estate should
be measured in the hands of your client's heirs.
If the heirs spend or withdraw the Roth IRA money immediately
upon inheritance, the strategic value of passing on the Roth IRA
is lost. If the
heirs are interested in providing for their future, they will choose
to let the Roth IRA continue to grow, income tax-free, perhaps only
depleting the Roth IRA funds by their required minimum distributions
based on the heir's life expectancy. This exceptional tax-free growth
potential makes converting
to a Roth IRA a significant estate-planning tool. The dollar value
of the inheritance at the time of death is paltry compared to its
potential worth when it is kept in the tax-free environment for
as long as possible. So,
how do you measure the potential
value of a Roth IRA?
The Sustained Significance of a Roth IRA
For our scenarios, the heir is an only child
who is 50 years old when the second parent dies. At fifty years
old an individual has an actuarial life expectancy of 33.1 years.
Assuming the beneficiary makes an election to receive distributions
over his or her lifetime, the minimum required distribution for
the first year would be the balance in the Roth IRA divided by 33.1,
or roughly 3% of the balance.
The minimum distribution for the second year would be the
balance at the end of the previous year divided by 32.1.
For the third year, the minimum distribution would be the
balance at the end of the previous year divided by 31.1, etc.
This is analogous to the term-certain distribution method
based on a single life expectancy.
The following examples show that, over time,
your heirs can realize appreciably more value from a Roth IRA inheritance
than an inheritance of after-tax investments.
The projected advantage of the Roth IRA is expressed as a
percentage of the value of the inherited after-tax funds.
For example, if the Roth IRA funds will produce 10% more
in benefits for the heir, then the value will be 110% of the value
of the after-tax fund inheritance, and therefore, have a 10% advantage.
Example
I
Let us compare an heir who inherits $100,000
in a Roth IRA to an heir who inherits $100,000 in after-tax investments.
The investment rates of return and other basic assumptions include:
- An overall return on investment (ROI) of
8% per year. Of the overall rate of return, 70% is capital appreciation
and 30% is ordinary income from interest, dividends, and short-term
capital gain.
- Of the accumulated capital appreciation,
15% of the beginning of year balance is realized as long-term
capital gains from portfolio turnover. (Please
note that the previous two assumptions, while probably realistic,
diminish the value of the conversion.
If the child invests in taxable bonds so that there would
be no capital appreciation and 100% ordinary income, the benefit
of the Roth conversion would be significantly higher than the
numbers indicate).
-
A
50 year old has a standard life expectancy of 33.1 years, and
this establishes the annual required minimum distributions from
the Roth IRA. Each year both heirs will withdraw and spend only
an amount equal to the minimum required distributions from the
Roth IRA.
-
The
income tax rates on investment income produced by the after-tax
funds are 28% federal and 3% state for ordinary income, and
20% federal and 3% state for long-term capital gain income.
The results of the calculations are outlined
below. It shows the age of the beneficiary and the total funds available
for the beginning of each of the first five years and each five-year
period thereafter. Also shown is the annual spending amount for
these years based on the minimum required distribution from the
inherited Roth IRA. Additionally,
we include a column that estimates the income taxes that would have
to be paid on the after-tax investments
for the year presented.
Chart
I
| Beneficiary's |
Available
Balance at Beginning of Year |
Taxes on |
| Age at Start |
Inherited |
Inherited |
Annual |
After-Tax |
| Of Year
|
Roth IRA Funds |
After-Tax Funds |
Spending |
Funds |
| 50 |
$ 100,000 |
$ 100,000 |
$
3,021 |
$
780 |
| 51 |
104,979 |
104,199 |
3,270 |
1,039 |
| 52 |
110,107 |
108,225 |
3,540 |
1,268 |
| 53 |
115,375 |
112,075 |
3,833 |
1,473 |
| 54 |
120,772 |
115,735 |
4,150 |
1,657 |
| 55 |
126,283 |
119,187 |
4,494 |
1,822 |
| 60 |
154,807 |
132,206 |
6,702 |
2,443 |
| 65 |
181,553 |
133,152 |
10,031 |
2,781 |
| 70 |
197,895 |
110,291 |
15,106 |
2,768 |
| 75 |
186,618 |
42,671 |
23,039 |
2,106 |
| 80 |
113,499 |
0 |
36,613 (a) |
0 |
Spending during age 80 is
available from the Roth IRA inheritance only, since the after-tax
inheritance is fully depleted by age 77.
As time goes on, the value
of the remaining Roth IRA inheritance is greater than the remaining
after-tax inheritance due to the tax-free growth of the Roth IRA.
A graph of the balances remaining at different ages for the beneficiary
follows:
For the non-conversion scenario,
income taxes must be paid on the investment income of the after-tax
funds. The combination of the tax withdrawals and spending withdrawals
(at the same rate as the tax-free spending withdrawals from the
Roth IRA) reduce the principal to zero by age 77, whereas the Roth
IRA would still have $167,647 available. The Roth IRA funds "run
out" at age 84 because of the minimum distribution requirements.
We can continue the comparison past the time the after-tax inheritance
is gone by showing, as an annual benefit, the minimum distribution
from the Roth IRA until it is gone as well.
However, one should not determine value by how long the minimum
distributions last because the minimum distribution amounts increase
significantly during these last years.
Even
considering the effects of inflation, the required minimum distributions
from the inherited Roth IRA increase significantly. Assuming 4% inflation
as a conservative, i.e. high, approximation of the long-term inflation
rate, a graph in constant dollars of the annual amounts spent follows:
This graph shows that the
last years of minimum distributions are the greatest.
From Chart I, the $36,613 annual spending amount during age
80 translates into $10,854 in today's dollars, as is reflected in
the graph above. We have assumed the above spending pattern for
distributions from both the conversion scenario and the non-conversion
scenario.
Obviously, the heir who received
the Roth IRA funds has received more than the other heir. How do
we measure this additional value?
Measuring
Value with Present Value Calculations
Present value calculations
provide a way to figure out how much money you would need
to have today, invested at a typical interest rate, to give
you the same amount of money that, in the case of our example, will
be inherited. In other words, for our example, the present value calculation
tells you how much you should be willing to pay now to buy your future inheritance: how much should you be willing
to pay for the Roth inheritance vs. the after-tax inheritance.
By simply projecting the dollar
amounts, as illustrated above, the amounts received in the future
seem very large, but that is because there is a long time lapse
between now and then—you could achieve the same large numbers by
investing a small amount now, and that smaller amount is the “present
value” of the future income.
The present value discount
rate we will use is 7%, which estimates an expected rate of investment
return of about 8%, less about 1% for income taxes on the investment
income that would have to be paid if the money was not invested
in a Roth IRA.
We also examine the effects
on the inheritance should it grow at a higher than expected rate
such as 11%. However, we do not change the present value discount
rate used in valuing future spending withdrawals since it is an
expected growth rate. We increase both the Roth IRA inheritance
and the after-tax inheritance by this 11% annual growth rate and
compare the results using the present value discount rate. This
projection demonstrates that the comparative advantage of a Roth
IRA inheritance is greatly increased if an above-average rate of
investment return is achieved.
In other words, if your heirs are able to achieve an 11%
return on the inherited Roth IRA, then it will be an even more valuable
inheritance than after-tax funds earning the same return.
An inherited Roth IRA has
a minimum distribution requirement that is calculated based on the
beneficiary's life expectancy. Assuming that each year both individuals
spend an amount equal to the minimum distribution from the Roth
IRA, the Roth IRA inheritance lasts longer. The beneficiary of the
after-tax investments has to withdraw additional amounts from the
after-tax inheritance to pay the taxes on investment income to end
up with the same amount of spending money as the beneficiary of
the Roth IRA.
Beginning in the first year,
the remaining balance in the Roth IRA becomes higher than the after-tax
funds. Therefore, measured through any given time in the future, the
present value of the inheritance can be measured by the total of
all the present values of each annual withdrawal plus the present
value of the remaining balance at the time the Roth IRA will be
depleted.
Using the information from
our example above, the following chart shows the results measured
through the end of each five-year period into the future:
Chart
II
| Beneficiary's |
Present
Value of Available Balance
at the Beginning of the Year |
Present Values
of |
Age at
Start of Year |
Inherited
Roth IRA Funds |
Inherited
After-Tax
Funds |
Spending Withdrawals |
| 51 |
$ 98,111 |
$
97,382 |
$
2,824 |
| 56 |
87,885 |
81,564 |
17,448 |
| 61 |
76,248 |
63,490 |
32,980 |
| 66 |
63,020 |
44,372 |
49,530 |
| 71 |
47,969 |
24,451 |
67,252 |
| 76 |
30,738 |
3,606 |
86,411 |
Please note that in Chart
I, the Roth IRA funds seemed to grow substantially for 20 years
after inheritance because it shows the actual dollar balance. But
Chart II, measures the funds in terms of present value.
By adding the cumulative present
values of the spending to the present values of the beginning of
year total funds available, we can now measure the percentage
by which the value of the Roth IRA inheritance exceeds an inheritance
of the same amount of after-tax funds.
Beneficiary's
Age at the |
Percent Advantage
Achieved by |
| Beginning
of the Year |
Roth IRA
Funds |
| 56 |
6.38% |
| 61 |
13.22% |
| 66 |
19.86% |
| 71 |
25.65% |
| 76 |
30.14% |
This tells us that by successfully
keeping the distributions from the Roth IRA funds to a minimum for
25 years, the 50 year old beneficiary has achieved a value from
the Roth IRA 30% greater than after-tax funds.
This would indicate that $1.00 of Roth IRA money in an estate
is really worth $1.30 if the beneficiary takes only minimum distributions
over his/her life expectancy.
This is a reasonable assumption since it is to the beneficiaries
advantage to not withdraw any more than the minimum from the Roth
IRA that is growing income tax free.
But we like to see other “what-if” scenarios, so let's play
with the numbers.
The famous Ibbotson study,
which detailed the history of investment returns from 1926 onward,
concluded that money invested in the S&P 500 Index from the
beginning of 1926 to the end of 1998 earned 11.2%. Even if we round
down the 11.2% to 11%, and use an 11% investment rate of return
instead of 8%, with all other factors being the same, the 30% advantage
by age 75 becomes a large 53% advantage. This means that given a
rate of return less than the historical S&P 500 Index, and assuming
the beneficiary withdraws only the minimum distribution from the
Roth IRA, $1.00 of a Roth IRA in an estate is really worth $1.53
to a 50 year
old
beneficiary.
Using the original 8% rate
of return, if the beneficiary's federal tax rate on ordinary income
is 39.6% instead of 28%, the 30% advantage becomes a 35% advantage.
Combining both these new assumptions,
i.e. 11% return on investments and the 39.6% tax bracket, the 30%
advantage becomes a more significant 65% advantage.
Stated another way, this means that inheriting $100,000 in
a Roth IRA is actually worth $165,000 to the heir.
The graphic portrayal of the
Roth IRA advantage for all these scenarios is as follows:
Now let's have some real fun. Please assume that the beneficiary is a five year old grandchild,
not a 50 year old adult child.
Naming a five year old (of course in trust) increases the
life expectancy upon inheritance from 33.1 years to 76.6 years.
The higher life expectancy allows the beneficiary to continue
Roth IRA tax-free growth for much longer, as well as decreasing
the required distributions in the earlier years. The minimum required
distribution, for the grandchild, for the first year would be the
balance divided by 76.6 (years) versus the balance divided by one
33.1 (years) for the 50 year old adult child.
Keeping the original assumptions
of an 8% return on investment and the 28% tax bracket, the Roth
IRA inheritance advantage for the five year old grandchild for the
initial 25 year period is somewhat better than for the 50 year old
adult child—37% instead of 30%. However, the time horizon for comparison
can be much longer. After the interval between 50 and 55 years of
age, the advantage the Roth IRA inheritance has over the after-tax
inheritance, is a tremendous 71%.
Continuing the analysis until all Roth IRA funds are withdrawn
(and assumed spent) until age 81, we find the advantage peaks at
80%.
These analyses incorporate
the present value discount rate. Representing the gains in future
dollars would make the total dollar amounts much greater. If the
five year old child is fortunate enough to be in the 39.6% tax bracket
and to achieve an 11% return on investments, he/she will achieve
a maximum advantage of 329% just prior to the time the Roth IRA
inheritance is fully spent at age 80.
This means for a five year old grandchild, an inherited Roth
IRA may be worth well over three
times the value of inherited after-tax funds.
The graph that follows plots
the Roth IRA advantage for both scenarios; with 8% and 11% returns
on investment and the 28% and 39.6% tax brackets:
We could go on and on with
variations on the assumptions, but it becomes clear that in the
hands of a child, or better yet a trust for a grandchild, an inherited
Roth could dwarf
the value of the same funds in the after-tax environment.
Conclusion
These illustrations graphically
demonstrate the potential value Roth IRAs have in an estate. Making
a significant Roth IRA conversion is usually very beneficial for
both your clients and their heirs. This article supports arguments
in favor of a Roth IRA conversion even if the conversion does not
significantly alter the total dollar value of the estate at the
time of death. The point is that even in the case where the conversion
results in a breakeven for the original IRA owner, when the child
or grandchild beneficiary elects to take only minimum distributions
from the Roth IRA, the Roth IRA's value is substantially greater
than the value of the same amount of after-tax funds.
However, the challenge of turning the inherited Roth IRA
into a gold mine will fall to your heirs.
It is essential that your clients and their beneficiaries
understand that the value is achieved over time, and that the Roth
IRA should be preserved in its tax-free environment as long as possible.
About
the Authors
Steven
T. Kohman works with the James Lange and Associates.
He is a Certified Public Accountant and a Certified Estate Planner.
Steven “runs the numbers” for the firm's retirement and estate
and planning clients to see how their estate monies will grow and
be spent during the owner's lifetimes and how they can best provide
for their beneficiaries.
James
Lange, CPA, JD educates and provides specialized retirement
and estate planning services to financial professionals and
individuals with significant IRAs and other retirement plan
accumulations. Jim
has over 20 years of experience in CPA and law firms in the tax,
retirement and estate planning areas. You can contact Jim by phone
at 1-800-387-1129 or via e-mail at admin@faculty-advisor.com. |
