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Roth IRA may be key to heirs’ tax savings

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Dear Dr. Don,
I have a considerable amount of money in 401(k) investments and stock. What is the best way to pass these assets on to my children after I’m deceased without them having to pay a lot of inheritance or estate taxes?

— Karen Conundrum

Dear Karen,
It’s a common retirement investor’s question: How do you turn the tax-deferred compensation in your retirement accounts into tax-free distributions for your children? Unfortunately for you and others, the government works very hard to make sure it gets its share.

Still, you are to be commended for looking into this for your heirs. Your family would likely benefit from tax planning. You’ll need to work with a tax professional to make that happen.

One potential strategy is to make a series of Roth IRA conversions. This would have you paying money into a Roth IRA in a series of conversions to manage the tax impact each year. One advantage of a Roth IRA is that it doesn’t have required minimum distributions during your lifetime. The beneficiaries of the Roth funds, assuming the account is titled and structured properly, can stretch the tax-free distributions over the beneficiaries’ lifetimes. This is complicated. So, it is not a do-it-yourself project.

Another potential strategy is to move the funds over time into taxable accounts. You’ll pay the tax on the distributions out of the tax-deferred retirement accounts, but when the children inherit the holdings in the taxable account, they’ll get a step up in basis, which effectively eliminates any capital gains in the investments during the time that you owned the taxable investments.

For 2015, the estate tax exclusion amount is $5.43 million. That number is indexed for inflation each year, so it will go higher in the future. For estates below the amount of the estate tax exclusion, no federal estate tax is due. State estate or inheritance taxes, however, could also be owed by the estate.

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