This is another in a series of blogs on the basics of estate planning. In this blog, we’ll look at the differences between a Roth and a traditional IRA (or 401k). We’ll also look at considerations in choosing between them.

With a traditional IRA (or 401k), you make a contribution and that amount is not included in your taxable income for the year. Contributions are limited to $5,500 (plus $1,000 if over age 55) for an IRA (or $18,000 (plus $6,000 if over age 55) for a 401k). When you take distributions from the traditional IRA (or 401k), the amount of the distribution, which may include the original contribution or earnings thereon, is taxed as ordinary income. Generally, Roth IRA (and 401k) distributions are not taxable, including all the earnings on the contributions.

With either one there are penalties for taking distributions prior to age 59 ½, unless an exception applies. With a traditional IRA (or 401k), you must start taking required minimum distributions once you reach age 70 ½, while with a Roth IRA (or 401k) you need take no distributions during your lifetime. This makes the Roth much more flexible from an income tax planning perspective. After death, the same rules apply regarding distributions to beneficiaries. Of course, the Roth distributions will not be included in the beneficiary’s income while the traditional distributions will be.

Generally, if you expect your taxable earnings and rate of taxation to be lower in retirement, you may lean toward contribution to a traditional account. On the other hand, if you expect the rate of taxation to be higher years down the road in retirement, you may lean toward a contribution to a Roth account.

Assets in a traditional or Roth 401k are completely exempt in bankruptcy. Assets in a traditional or Roth IRA are exempt in bankruptcy up to at least $1 million. Thus, if you have asset protection concerns, you’ll likely want to maximize your contributions. Effectively, by using a Roth vehicle, you are contributing greater value to the plan because each dollar contributed has the taxes pre-paid. Whereas with a traditional vehicle, the future income taxes have yet to be paid. Thus, if you have $100,000 in a traditional vehicle and it will be taxed at 30% upon withdrawal, the after-tax value will be $70,000. On the other hand, if you have $100,000 in a Roth account, even after distribution it is still worth $100,000.

If you have a taxable estate, you may want to consider a Roth vehicle. Let’s say you have an estate that exceeds the estate tax exclusion by $500,000. Thus, your estate would pay $200,000 in estate tax (after a 40% federal estate tax). Let’s say part of your portfolio is a $1,500,000 traditional IRA. Let’s say you could Roth that IRA by taking it into income and paying 1/3, or $500,000, in tax (perhaps over a couple years). By doing so, you would bring your estate down to the exclusion amount and remove the estate tax problem without reducing the value of your assets. Basically, all you’ve done is pre-paid the income tax you or your beneficiaries would have to pay, and by so doing, you would have saved $200,000 in estate taxation.

There are many advantages to saving for retirement. Carefully consider whether a traditional or Roth IRA (or 401k) is right for you or your client.

In upcoming blogs, I’ll discuss more on the basics of estate planning.

Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com