THE ROTH IRA'S OTHER EDGE: ESTATE PLANNING

In the 24 years since they were created, individual retirement accounts (IRAs) have served mainly as a way for individuals who don't have a company retirement plan to build a nest egg using their own, tax-deductible contributions. Then last year, Congress changed the rules of the game significantly by creating the Roth IRA, which in addition to being a retirement savings plan offers the tantalizing prospect of shielding assets for a lifetime -- and after.

Increasingly, estate planners and senior citizens are recognizing that Roth IRAs are a good vehicle for passing money on to heirs. If you have a traditional IRA, that gives you a couple of options: You can set up a new Roth IRA and put your future contributions into that instead of into your old IRA. Or you can go further and convert your existing IRA plan to a Roth. Assuming that your income is within the allowable limits for setting up a Roth, you may certainly want to do the former. Whether you take the second step may depend on whether you're willing to pay taxes of up to 36% on your current retirement savings as you transfer the assets of your old IRA into a Roth.

Congress created the Roth IRA as part of the Taxpayer Relief Act of 1997 and let taxpayers start using it last January. Named after Senator William Roth (R-Del.), who sponsored the legislation, the Roth IRA is like a traditional IRA in that it permits annual contributions of up to $2,000 and allows assets to grow tax-free. And as with the traditional IRA, eligibility for the Roth is determined by income level: It phases out for married couples with so-called modified adjusted gross annual incomes (excluding capital losses) of $150,000, and for single filers at $95,000. One other similarity of the two IRAs is that, with few exceptions, if you withdraw money before age 59 1/2 you pay taxes on the amount, plus a 10% penalty to boot.

Once you've determined whether you qualify for a Roth, you'll want to concentrate mainly on the differences between the two plans. For instance, while contributions to a traditional IRA are tax-deductible, the money you put into a Roth isn't. However, you'll have to pay taxes on the money you withdraw from a traditional IRA (though presumably at a lower rate, since you'll be retired). By contrast, the income you'll take from a Roth is tax-free.

So-called minimum distribution rules -- which govern how long you may contribute to your IRA, and how long you may keep money in it -- are another area where the two plans differ markedly. With a traditional IRA, you can start making withdrawals at age 59 1/2, no matter at what age you set up the account. With a Roth IRA, you have to wait five years after your initial contribution before you can start making penalty-free withdrawals.

With a traditional IRA, to cite another difference, you have to stop making contributions and begin emptying your plan after age 70 1/2 or face tax penalties. With a Roth IRA, though, you can leave your savings in the plan and continue to make contributions for the rest of your life. That's a big advantage. As the average lifespan of Americans lengthens, the IRS-mandated withdrawals from traditional IRAs can substantially diminish, even wipe out, the account before you die. With a Roth, you can continue to pad your nest egg.

The fact that you don't have to withdraw any of the money from your Roth during your lifetime also makes it an attractive tool for leaving tax-free assets to your children or grandchildren -- a key feature estate planners have discovered.

The payout schedule for your existing IRA is based on your life expectancy. If you are 70, your life expectancy is 16 more years. So your traditional IRA must be emptied over that period. Your life expectancy -- and the age at which you name an heir -- also determines the rate at which your heirs must withdraw money from your traditional IRA. For example, if you make your grandson your beneficiary after you reach age 70 1/2, your grandson must continue to empty the account at least as rapidly as you were emptying it during your lifetime.

If you named your grandson as your beneficiary before reaching age 70 1/2, though, the payout schedule would be determined based upon your combined life expectancies, a calculation you make using IRS mortality tables. The IRS rules hold an unpleasant surprise if you beneficiary is someone other than your spouse. In such as case, the IRS assumes that your heir is only 10 years younger than you. So even if your grandson were 26 when you reached age 70 1/2, the IRS will assume that he was 60. That will shorten your combined life expectancy significantly -- and require a pretty short payout.

By contrast, the Roth legislation implies that your heirs may have a longer time over which to withdraw money you bequeath them -- meaning that the money that remains in the account can continue to compound tax-free. That's because with a Roth, the original owner's life expectancy is taken out of the payout equation. For example, if your grandson is 26 when you die, he'll be entitled to draw money for the Roth over the next 56 years -- based on his life expectancy at age 26. One word of caution, though: The IRS has yet to issue final regulations on how Roth money will be taxed after you're gone.

Given the Roth IRA's advantages, it's easy to see why you might want to set one up. Your first option is to reduce or stop contributions to your traditional IRA and instead put your future contributions into a new Roth, or into a combination of it and your old IRA. Whichever you choose, you'll be limited to the same $2,000 annual contribution that applies to your current IRA.

Your other option is to convert your traditional IRA to a Roth. There's a catch, of course: You're eligibile to do the conversion only if your adjusted gross income is $100,000 or less -- a cap that applies for both married and single filers. Congress is considering a measure to raise the $100,000 limit to $145,000 for single filers and $290,000 for joint filers. Also, legislation was enacted in July to exclude from the income calculation withdrawals that many people over 70 1/2 are forced by tax laws to make -- and that put them over the $100,000 limit. However, that law doesn't take effect until after 2004.

If you fall within the income limit for starting a Roth, remember that you still have to evaluate your options. That's because when you transfer funds from your traditional IRA to the Roth, the money will be taxed as income. You can pay the tax bill by either sacrificing a portion of the savings in the IRA or by paying out-of-pocket. Many financial planners recommend paying the tax out of current income, if possible, to preserve your retirement savings. Congress attempted to lessen the pain by making a special exception for people who change plans in 1998: If you do so by yearend, you'll be able to stretch out the tax payments on your old IRA over four years.

Conflicting advice from estate and financial planners illustrates how hard it is to decide which path to take. If you're already retired, some planners question whether it makes sense for you to convert to a Roth IRA -- and pay 36% of what you have in your existing IRA in taxes, just to be able to leave the investment to a grandchild in the 15% tax bracket. Others contend that converting allows seniors to pre-pay income taxes for their heirs and cuts estate taxes by shrinking the size of their estate. You'll find a multitude of opinions on the subject at www.rothira.com -- including discussions on how to reconvert your Roth to a traditional IRA. That Web site is run by Brentmark Software, which develops estate, financial, and retirement planning software for professional financial advisers.

You have plenty of reasons to be cautious before converting. The Roth IRA is in its infancy and has known only a surging stock market and strong economy. Paying taxes out of existing IRA savings to trade up to a Roth may become less palatable if the current stock market correction continues. Also, Congress could always change the features of the Roth IRA (as it has done before with traditional IRAs). And questions about whether Roth IRAs are protected from creditors in some states, or are exempt from state income tax in others, have not yet been fully answered.

So while the Roth IRA presents an exciting new option for both estate and retirement planning, it is still somewhat a work in progress. At the very least, however, it gives you options for retirement and estate planning that you didn't have before.

By Steven D. Roll

Steven D. Roll is an editor at Tax Management Inc., a subsidiary of the Bureau of National Affairs