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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22 Replies to “The Magical Roth IRA”

  1. Great post!

    Can you elaborate on how this can be used in perpetuity? Does the heir then have the ability to (re)designate a beneficiary for the same Roth IRA, or would they have to start a new Roth for their heir?

    1. Thank you.
      I haven’t seen guidance on whether an inherited Roth IRA can be re-gifted for another generation.
      I doubt it, but I haven’t been able to find an answer one way or another. I’d be grateful to any tax expert who knows for certain who wants to weigh in.

  2. Give it time, the government will surely do something to close this “loophole”. I also assume we’ll eventually get a VAT as well.

    Bottom line, don’t put your eggs all in one basket. This includes the traditional asset allocation, but also taxable vs retirement accounts, and even national vs international.

    1. Actually, I’d bet this loophole stays, or at least is ‘grandfathered’ for anyone who has created a Roth IRA already.
      Why do I think Roth IRAs will continue, or at least be grandfathered?
      Because there’s a strong overlap between the kind of families who can most benefit from a Roth IRA as a perpetual money machine and the kind of people who contribute to congressional campaigns.

        1. Good stuff. Great concept for hard working folks who have rode the ebbs and tides of the stock market and now waiting to just pull back and let the power of a solid interest rate (which is just around the proverbial corner) let the ship come home.

          Great post!

    2. You can find many examples in the US tax code where politicians created policies that would directly benefit them. This is ome of them, so I doubt Congress will change this anytime soon. And I highly doubt we’ll ever be going to a VAT system since it would only increase the wealth inequality that already exists.

  3. I agree with DH, great post!

    If I wanted to start saving money today in a Roth IRA, specifically for my two daughters, would it be smarter to:

    1. Put the Roth IRA in my name and my wife’s name, and then pass it along to our daughters, to alow for the minimum distributions, or does it make more sense to set it up in our daughters names, alowing them to pass along any potential residual balance to their children?
    2. Put the Roth IRA in my name and my wife’s name, and then pass it along to our gradchildren, so that our daughters can enjoy the benefits of the mandatory tax free distributions (which I understand are technically in our grandchildrens names), and then our grandchildren can benefit from having large nest egg when they go to retire. Sort of a win/win for both our children and grand children.

    Thank you for all the great information!


    1. Without knowing more specifics of your situation, but assuming you and your wife really won’t need any of the money in your lifetime (which would obviously make you want it in your name if you did), and further that you want to take the most advantage of the ‘perpetual money machine’ aspect of the Roth IRA (i.e. tax-free distributions), then my advice is to sock away money in an IRA in the name of the youngest possible person.
      Youngest person = longest growth period for compounding returns.
      If that’s your daughter, then your daughter. If your grandchildren have any earned income (babysitting, lawnmowing, summer jobs, filing papers at the office for Mom or Dad) then they can open up a Roth in their name up to the amount of the earned income and up to the max allowed ($5.5K this year).
      In sum, if you’ll never need the money, and the account is purely to maximize future money for heirs, then seek to open it for the youngest possible person, and then also leave it in the estate to be inherited by the youngest possible person. Make sense?

  4. We converted our IRAs to Roth multiple times and grew the assets. Now that our kids adults, we are entering the next stage of estate planning and facing issues we did not anticipate. Roth as an estate planning tool assumes responsible heirs and I am not sure how common they are! We need to put one kid’s assets in a trust for someone else to administer. Since inherited Roth’s have to be owned by someone and paid out based on their life expectancy (or ours),I am not sure the trust can retain the Roth tax benefits. Contacting a lawyer but would appreciate any knowledge others have.

  5. I love my Roth, trade stocks and never have to worry about tax’es. I used to have a cash account with TD Ameritrade also and it was a royal PITA at tax time. Especially if you had any wash sales! Anyway I started my Roth in 2005, principle is $30500.00, about @ $64000 today, my goal is at 58 yo and retired, to double this again and eventually buy dividend stocks for that quarterly check as extra cash IF I need it. I am an active trader. I like doing swing trades, heeby jeeby day trading isn’t my style sitting at a computer all day, too much like work!

  6. I have read your post, The Magical Roth IRA several times. It is wonderful. The example makes everything concrete. Thanks for the post.

  7. Did the rules change since this article was written as I have seen elsewhere that the person who inherits the Roth does not get to adjust ther Required Minimum distribution life expectancy each year, but rather adds one to the beginging one and goes from there. In your example the kid, who inherited it at age 5, at age 25 would have a RMD of 20/77.7 about 27%

    1. Nick, you are right, and I got it wrong. The initial age of inheritance sets the RMD in the first year according to life expectation, then add one % to the RMD each year. I need to fix that in this post.

      1. Not to be too particular, but it may be a point of confusion for some (me) and may make a huge difference in calculating the correct RMD…

        I think it would be clearer to state: “The initial age of inheritance sets the RMD in the first year according to life expectation, then subtract one year from life expectation for each following year to calculate subsequent RMDs.”
        Of course, it’s probably best to go straight to the horse’s mouth:

        Per IRS Publication 590-B:

        Roth IRAs:
        If a Roth IRA owner dies, the minimum distribution rules that apply to traditional IRAs apply to Roth IRAs as though the Roth IRA owner died before his or her required beginning date.
        Distributions to beneficiaries. Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner’s death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary. See When Must You Withdraw Assets? (Required Minimum Distributions) in chapter 1.
        If paid as an annuity, the entire interest must be payable over a period not greater than the designated beneficiary’s life expectancy and distributions must begin before the end of the calendar year following the year of death. If the sole beneficiary is the spouse, he or she can either delay distributions until the decedent would have reached age 70½ or treat the Roth IRA as his or her own.

        Traditional IRAs (same rules apply to Roth IRAs as though the Roth IRA owner died before his or her required beginning date):
        Other designated beneficiary (other than spouse or estate). Use the life expectancy listed in the table next to the beneficiary’s age as of his or her birthday in the year following the year of the owner’s death. Reduce the life expectancy by one for each year since the year following the owner’s death. As discussed in Death of a beneficiary, earlier, if the designated beneficiary dies before his or her portion of the account is fully distributed, continue to use the designated beneficiary’s remaining life expectancy to determine the distribution period; do not use the life expectancy of any subsequent beneficiary.

        Your father died in 2015. You are the designated beneficiary of your father’s traditional IRA. You are 53 years old in 2016, which is the year following your father’s death. You use Table I and see that your life expectancy in 2016 is 31.4. If the IRA was worth $100,000 at the end of 2015, your required minimum distribution for 2016 would be $3,185 ($100,000 ÷ 31.4). If the value of the IRA at the end of 2016 was again $100,000, your required minimum distribution for 2017 would be $3,289 ($100,000 ÷ 30.4 (31.4 reduced by 1, which is the number of years following the year after your father’s death in 2015)).

  8. Wow, Thanks for this great explanation! I’ve been toying with the idea of doing a traditional IRA conversion to Roth, and I think you just pushed me over the hump. I’m doing it.
    I found this article very helpful as well.

    Thanks again for the help, and I will keep reading!


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I founded Bankers Anonymous because, as a recovering banker, I believe that the gap between the financial world as I know it and the public discourse about finance is more than just a problem for a family trying to balance their checkbook, or politicians trying to score points over next year’s budget – it is a weakness of our civil society. For reals. It’s also really fun for me.

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