by Gregory Kolojeski
© 1997, 1998, Gregory Kolojeski
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The name of the game is deferral
For the Roth IRA, the name of the game is deferral. When all is said and done, what makes the Roth IRA such a wonderful wealth accumulation device is not just the tax-free nature of distributions. The power of this concept is the potential of additional decades of tax deferral beyond what is offered by a ordinary IRA. Even with a Roth IRA, the tax-free growth will eventually end as required distributions convert the IRA assets back to property that generates taxable income.
An ordinary IRA also offers considerable tax deferral. Ordinary IRAs also give you an upfront tax deduction as well. The price you pay is taxation at ordinary income rates when you are forced to start taking withdrawals starting in your age 70½ year. With a Roth IRA, you get no upfront tax deduction, but you do get tax-free withdrawals (after a five year period). If this was the only distinction, the analysis of the advantage (if any) of the Roth IRA would hinge largely on income tax rates. If income tax rates at the time of withdrawal were to be lower than at the time of contribution (or conversion), then the Roth IRA would generally be less attractive than a ordinary IRA. (The word generally is used because there are exceptions even to that premise, especially when the federal estate tax is factored in.)
No minimum distributions at age 70½
What makes the Roth IRA so powerful is that minimum distribution rules do not kick in for the participant’s age 70½ year. There are no required minimum distributions until after the death of the participant. If he lives until age 85, there will have been an additional 15 years of tax deferral to that point. And there is potentially 15 more years of continuing contributions as well (if there was earned income during that period). Ignoring the possibility of a spousal beneficiary (or a spousal rollover) for the moment, let’s assume that required minimum distributions now start the year following the participant’s year of death. Those distributions will be payable to the participant’s beneficiary using a single life term certain method. Let’s assume that beneficiary is a child 25 years younger than the participant. The beneficiary would now receive tax-free distributions over a 24 year period (based on a single life expectancy of 23.3 being decreased by 1 each year). Even if the beneficiary died during that period, the distributions need not be accelerated, but could continue tax-free to the recipient for the full 24 years!
From an economic viewpoint, what is happening when the participant’s beneficiary is forced to take minimum distributions (as in the preceding example for 24 years)? You can look at that distribution period as being the period in which tax-free growth is eventually converted to taxable growth. Each required minimum distribution is itself tax-free, of course. If that required distribution is itself invested, that ensuing growth will then usually be taxable. Thus, distributions over 24 years could create a new fund whose growth is taxable. Yet, there is a lot of tax deferral being accomplished during the 24 year period. And this is on top of the tax deferral that occurred during the participant’s life.
Spousal rollover increases deferral period
Now, let’s assume that the participant dies at 85 with a surviving spouse as the designated beneficiary. Let’s assume she is age 80 at the time and now treats the IRA as hers (a spousal rollover of an inherited IRA). Under the spousal rollover rules, she now treats the Roth IRA as if it were originally hers. (Not only does the IRS’ Model Agreement clearly allow for spousal rollovers, it makes the spousal rollover the normal case.) As the owner of the IRA, she does not have to make any minimum distributions during her life. She can use this period from the original participant’s death to her death as another period of additional tax-free growth. If she lives to age 90, then we have another 10 years of potential tax deferral tacked on to the original participant’s.
Two components of tax deferral
The extra deferral offered by a Roth IRA has two major components. The first is the post-70½ deferral period that generally lasts until the death of the second-to-die of the husband and wife. Any evaluation of the Roth IRA should rightfully focus on this deferral. Of course, this deferral ends at death. As such, it is not guaranteed and would not be achieved in cases of early death. The second component of tax deferral offered by the Roth IRA is the tax-free growth of the Roth IRA assets during the single life expectancy period of the beneficiary, often a child. For there to be significant advantage to this second component, it is important that income taxes due to the conversion be paid from other assets than those in the IRAs. (Even if conversion taxes are paid from an IRA, the first component of tax deferral will still make the Roth IRA conversion the better alternative in many cases.)
Tax-free growth may continue after death
The after-death tax-free growth component can be an important issue in a Roth IRA analysis. In some cases, this future tax-free growth arguably makes the Roth IRA more valuable than the ordinary IRA even the day after you convert. For example, let’s assume a death at age 50 with a child as the beneficiary who is 25 years younger. That 25 year old would have a life expectancy of 57.0 years. If he were not to withdraw the Roth IRA any faster than required, he would withdraw 1/56 of the balance when 26 years old, 1/55 of the balance when 27 years old, etc. During all that time, the IRA balance would grow tax-free and distributions would be tax-free to the child. If the funds had been left in an ordinary IRA, the same deferral period would still apply. However, all the growth would be taxable as distributions are made from an ordinary IRA. If both IRAs have the same starting balances, the value of the after-death growth in the Roth IRA will be much higher than in an ordinary IRA.
How can the ordinary IRA and Roth IRA have the same starting balance if conversion taxes must be paid? Clearly, if the conversion taxes reduce the value of the Roth IRA (either if paid directly from the Roth IRA or if some amounts are left in the ordinary IRA to pay the taxes) and income tax rates stay the same, there would be little difference due to the effect of the tax-free growth. Either way, the taxes would be equivalent. However, if the conversion taxes are paid from other assets, there can be a substantial difference. By paying the Roth conversion taxes from other assets, a larger balance is being left in the Roth IRA to grow tax-free. The value of this additional tax-free growth has no counterpart in an ordinary IRA. You have effectively grossed-up your IRA balance by changing the balance from a tax-deferred value to a tax-free value. The value of the additional tax-free growth this generates in the Roth IRA will generally substantially outweigh the opportunity costs. Opportunity costs refer to how the other assets would have grown if not used to pay the conversion tax. Such growth on those other assets would generally be taxable. By using other assets to pay the conversion taxes, you are essentially converting assets with taxable growth to assets with tax-free growth.
Another potential deferral advantage from a Roth IRA is that due to the four year spreadout of additional taxable income when you do a conversion in 1998. However, that deferral may be offset in whole or part due to a higher income tax rate from being pushed into higher brackets during those four years. Then again, a conversion in a year after 1998 might result in still higher average tax rates and would not get a four year spreadout.
Avoid distributions as long as possible
Of course, all or part of the tax deferral is for naught if the IRA owner or his beneficiary needs to take out the money earlier. The key is when will distributions be needed? If distributions from the Roth IRA can be avoided for as long as possible, you and your beneficiaries will come out much further ahead. What a Roth IRA offers is additional decades of possible tax deferral beyond that offered by a ordinary IRA. Paying the conversion taxes from other assets also offers the ability to effectively convert taxable assets to nontaxable assets as well. Those benefits are what make the Roth IRA so powerful.
The Roth IRA, with its potential long period of tax-free growth and tax-free distributions may be thought of as the ultimate wealth accumulation device. It should be the last place from which you take distributions. Live on your taxable income and other assets. The Roth IRA offers extra decades of tax-free growth followed by tax-free distributions. There is no better tax shelter than the Roth IRA.
For the latest information on Roth IRAs, see the Roth IRA Web Site at www.rothira.com.
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