Tax law can make grandkids rich

Congress last year enacted temporary changes that allow for a massive estate-tax break through a Roth IRA. As a result, a grandchild could pocket millions, tax-free, over a life.

Sometimes Congress hands out a break that is so generous it seems it must be a mistake. This your a doozy: The ability to get a totally tax-free inheritance of $400 million or perhaps more.

Thanks to 2 recent changes in the tax code, investors with huge 401k accounts have a method to turn them into completely tax-free income for their grandchildren's lifetimes.

This is by far the biggest estate-planning break on record, created even as lawmakers debate over which tax giveaways should be killed to help shore up the federal budget.

"I call this tax break the government's going-out-of-business sale," says individual retirement account guru Ed Slott, that travels the country teaching advisers as well as accountants how to squeeze benefits out of the Roth IRA. "This is a tax break we can drive 10 Mack trucks through. It's an incredible opportunity to a totally tax-free transfer of wealth."

This massive estate-tax break was created last year in 2 steps. First, Congress lifted a $100,000 income restriction on that can convert a 401k to IRA to a Roth IRA, allowing even the wealthiest investors to convert. Then, late in the year, it raised the generation-skipping transfer tax exemption to $5 million until 2013. The GST exemption was previously $3.5 million as well as was scheduled to drop to $1 million this year before Congress stepped in.

Both of these provisions on their own create possibilities for important tax savings, upon conversion. But utilized in combination, the results are exponentially greater.

The Roth IRA has always been on a different playing field compared with alternatives, due to the fact it allows gains to be withdrawn tax-free. Funds taken from a 401k, regular IRA or other retirement accounts is subject to income tax rates. Also, the Roth doesn't need that minimum distributions be taken after we turn 70½, as other plans do. Thus if you don't want retirement plan assets to live on, the Roth preserves it best for heirs.

Certainly not everyone jumps at the chance to convert to a Roth IRA, because we have to pay income taxes on the assets moved into the account. And so if you plan to live off of retirement account assets, a conversion may definitely not make sense. But from an estate-planning perspective, when there are decades of gains ahead, the tax bill is a small price to pay for big benefits down the road.

With the new GST exemption, the estate-planning benefits that can be wrung from a Roth are eye-popping. Consider an extreme case: A wealthy individual converts a large 401k account to a Roth IRA as well as names a grandchild as the beneficiary. The grandchild, at age 1, inherits the Roth, whose assets have grown to $5 million. Due to the fact of the new $5 million GST exemption, the Roth assets would not be topic to estate tax or perhaps generation-skipping transfer tax.

Under Roth rules, an heir should take needed minimum distributions, but the distributions can be stretched over a lifetime, and assets left in the Roth can continue to grow tax-free. Based on a 1-year-old's 81.6-year life expectancy and assuming an average annual return of 8%, Slott calculates that the grandchild's lifetime income from the Roth would definitely be $408 million -- "completely without estate, gift, income and capital gains taxes," he says.

If both grandparents left a big Roth account to the same grandchild, the tax-free inheritance would be almost twice that amount, depending on the age of the grandchild whenever the second Roth is inherited.


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