The Magical Roth IRA


[EDITOR’S NOTE: Some of the magic of the stretch Roth IRA got eliminated by the 2017 tax reform. So this post, while popular, is less accurate than it was when I wrote it in 2013. Roth IRAs are still lovely, but the stretch properties aren’t available]

Less than two weeks left to fund your 2012 IRA, so I’m continuing my series on these maddeningly humble, but potentially interesting, retirement accounts.

But, to get caught up, please see earlier posts on The Humble IRA,

IRAs don’t matter to high income people and A rebuttal: The curious case of Mitt Romney

The Roth IRA boasts a few magical advantages over the traditional IRA, but the most interesting one has to do with intergenerational wealth transfer.

Being a grandparent with some wealth to pass on to worthy heirs involves a seeming Catch-22: How can we give our sweet, beautiful, grandchildren easy money but still help them avoid the hookers and cocaine?

I have no suggestions for you with respect to the latter problems, but the Roth IRA can really help with the wealth transfer part, in a simple, low-cost way.

What’s unique is that the Roth IRA’s super-simple, low-cost, inter-generational wealth transfer tool otherwise doesn’t exist for middle-income folks.[1]

How the Roth IRA differs from the Traditional IRA on mandatory minimum distributions

With a traditional IRA, a retiree must begin withdrawing funds after age 70.5, in proportion to her age.  The formula for distributions, in fact, is calculated as Mandatory Distribution = Account Balance divided by Life Expectancy.

A 75 year-old retiree with $200,000 in a traditional IRA who has a 13.4 year life expectancy – according to IRS document 590 “Appendix C” in the hyperlinked document here[2] – must withdraw $14,925.37 this year, the result of dividing $200,000 by 13.4.

This is fine for people who need the money in retirement, although unfortunately withdrawals from the IRA account will be taxed as ordinary income.[3]

But for a retiree who does not need the money, and who would rather pass on as much money as possible to her heirs, the Roth IRA has a huge advantage over the traditional IRA because the Roth does not mandate any distributions during the retiree’s lifetime.

Thus, a Roth IRA can grow larger and for longer than a traditional IRA.  If the retiree chooses, she can eschew distributions from Roth IRA altogether until the account passes to her young heir.

Why does this matter so much? 

The magic trick of the Roth IRA is that, while annual distributions must begin immediately for heirs, a retiree may select a very young heir to inherit the Roth IRA, such as a grandchild or great-grandchild.

What that means is that annual ‘required distributions’ are very small, especially in the beginning, so that the account itself may become a kind of perpetual source of tax-free income for a child who inherits the Roth IRA.


Can I get an example please?

A concrete example helps illustrate the magic involved.

Our 75-year old retiree named a young beneficiary, say, 5 years old to inherit the Roth IRA with $200,000 in it.

I assume the deceased retiree’s total estate assets total less than the $5.25 million estate tax exemption, so her $200,000 Roth IRA passes estate-tax free to the child.

After the 5-year old child inherits the Roth IRA, minimum distributions must begin.

But the minimum distribution amount will be quite small, calculated again as the ratio of the account balance divided by expected life of the beneficiary.  Since a 5 year-old has an expected life of 77.7 years – again, according to this IRS appendix – the minimum income distribution from the account is just $2,574, or $200,000 divided by 77.8.[4]

Now, $2,574 in income is a small, good, thing for a 5 year-old to have, but that’s not the real point of the magical Roth IRA.  The real point is that the income will grow over time under ordinary compound interest conditions.  Since compound interest is, as we know, the greatest power in the known universe, this acorn of a Roth IRA carries within itself oak tree potential.

Financial Sustainability!

You see, the key point is that the minimum distribution to a 5 year-old kid is just 1.29% of the principal.  If the account can earn something close to a historical rate of return on long-term investments, let’s say 5%, then that Roth IRA grows significantly over time.  The gift just keeps getting better as the child grows up, for the rest of her life.

As I wrote before, one of the hardest parts about financial sustainability is that the percentage allowable distribution – typically 4% or 5% – might just reduce principal in a low-return environment like we’ve experienced lately, and at least runs a high risk of diminished purchasing power.[5]  This is a problem every foundation, school, hospital or individual retiree worries about right now, because distribution amounts are too high for the cumulative returns we’ve seen in the past decade, and the risk-free returns achievable now.

But the Roth IRA minimum distribution amount for young heirs, on the contrary, is utterly, awesomely, magically, sustainable.  As a result, all throughout this period, the odds are very good that the Roth IRA will grow in value in the long run, assuming the account is invested in an ordinary market, earning ordinary returns per year.

The lucky Roth IRA heir

Let’s follow this lucky 5-year old heir through time, as a beneficiary of the original $200,000 Roth IRA.

At 25 years old, the heir to the Roth IRA has a 58.2 year expected remaining life, and still would have to withdraw only 1.72% of principal.   After receiving tax free income distributions for 20 years,[6] assuming a 5% return on investments, the account is now worth $413,255 and the annual distribution has increased to $6,874.

When our beneficiary of the Roth IRA reaches 50 years old, with a 34.2 year expected remaining life, she may still withdraw only 2.92% of account principal.  Her inherited Roth IRA has grown to $815,005, and the annual draw is now up to $23,345, again tax free.

Not until the young beneficiary lives past age 66 – with a life expectancy of 20.2 years, do the Roth IRA minimum distributions go above 5%, the traditional threshold for financial sustainability.

By the time she reaches her own retirement age of 65 years old, the account is worth just shy of $1 million – more precisely $978,629 by my calculations – all assuming the minimum required distribution and a pedestrian 5% return every year.

Under this scenario of a 5% market return and minimum distributions, the lucky Roth IRA heir has taken home $957,344 in income over 60 years, paid no income tax on that money, and now controls an account worth $978,629.

As that guy from Entourage would say, is that something you might be interested in?

Could it be larger?  Absolutely

Just to dream a little bigger for a moment, what if the Roth IRA returns 7% per year over that period?

Why then, that lucky heir took home $2,274,512 in tax free income between ages 5 and 65, and at age 65 she controls an account worth $3,174,599.[7]

In sum, the US Congress created a perpetual tax-free money machine for inter-generational wealth transfers when it created the Roth IRA.

And it’s available to moderate income folks who can manage to accumulate significant assets in their Roth IRA.

Please see related posts on the IRA:

The Humble IRA

IRAs don’t matter to high income people

A rebuttal: The curious case of Mitt Romney

The 2012 IRA Contribution Infographic

The DIY Movement and the IRA

Angel Investing and the IRA

[1] At the higher level of inter-generational wealth transfer planning, we’ve got a myriad of tools involving trusts, foundations, and tax-advantaged vehicles for estate planning.  The estate tax exemption at $5.25 million sets the floor for diving heavily into this kind of legal, financial, and tax advice.  For the lower end of the market, however, the Roth IRA can be a really cool, nearly free, tool.  Kind of like using Google Calendar instead of having a personal assistant.  Or something.

[2] Start with the chart that begins on page 6 of the IRS document.

[3] An ordinary income tax rate will typically be worse than the 20% tax rate that might apply for long-term capital gains one might have in a non-IRA investment account full of appreciated stocks.  One of the tax-inefficient features of IRAs.  Which is why Mitt Romney’s (up to) $100 million IRA is not as sweet as it sounds.  What I really mean is, it’s sweet, but not as tax-efficient as it sounds.

[4] Another neat feature of this $2,574 is that its tax free because of the Roth IRA, although very few 5 year-old children would otherwise have any reason to worry about income taxes, so it’s kind of irrelevant to the example.  I guess little Shirley Temple or Drew Barrymore-type working kids would have benefitted from this income-tax free feature of the inherited Roth IRA.

[5] What I mean is that if inflation runs at 2%, and you spend 5% every year because that’s the mandated endowment draw, your market returns have to consistently beat 7% (5+2!) just to maintain your purchasing power at a steady state.  When risk-free bonds return 6% or more – as they did until 2000 and the 50 years before that –  a blended risky/riskless portfolio has a decent chance of clearing the 7% hurdle.  When risk-free bonds return 0.5% to 2% as they do now, you have to put all of your portfolio in risky assets to have any chance at achieving long-term sustainability with your endowment, or with your retiree savings.  Which is kind of uncomfortable, I think.  I discuss this further here.

[6] A total, in this example, of $85,456 in income.

[7] With that kind of Roth IRA account, just blast yourself out of a circus cannon into a whole mattress full of cocaine to celebrate your 65th birthday.  Afterwards, remember to gently and respectfully light a jasmin-scented candle for grandma, for her original $200K gift.

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