Which retirement savings vehicle is best for your estate plan?

When it comes to retirement accounts, you have many choices, including a traditional IRA, a Roth IRA, a 401(k) and, now, a Roth 401(k). You can use these retirement savings vehicles for estate planning purposes as well.

Weigh the choices

The main difference between traditional and Roth accounts lies in the tax treatment of the contributions and distributions. Even though contributions to traditional accounts generally reduce your taxable income, distributions are subject to tax. Roth contributions, on the other hand, don’t provide a tax benefit, but distributions generally are tax free.

Whether you even qualify to make tax-deductible traditional IRA contributions or any Roth IRA contributions depends on a variety of factors. See the chart accompanying this article for more information. If you qualify for both, should you choose a traditional or a Roth IRA? By extension, if your employer offers a Roth 401(k), should you choose a traditional or a Roth 401(k)? The decision hinges on two main factors: 1) the tax benefit now vs. tax-free withdrawals later, and 2) the flexibility of contributions and distributions after age 70¹/₂.

Even though you may not be eligible to make deductible or Roth IRA contributions, there may be an estate planning opportunity with respect to your grandchildren. As they begin their careers, you may be able to encourage them to make retirement contributions today by funding them. This will help your grandchildren to build their retirement accounts and, you hope, get them to focus on their financial future. And don’t forget that, if your taxable income drops as you scale back or change careers, you may become eligibleto make contributions to a deductible or Roth IRA.

Also consider that, unlike a Roth IRA, a Roth 401(k) has no income limits for contributions. So by forgoing the income tax benefits of contributing to a traditional 401(k), you may position yourself to pass income-tax-exempt funds to heirs.

Tax benefits on contributions vs. tax-free withdrawals

Let’s suppose you (or your grandchildren) are permitted to make a contribution to either a traditional IRA/401(k) or a Roth IRA/401(k). By choosing the Roth, you’d forgo the tax benefit that would be available if you had instead contributed to a traditional IRA or 401(k).

If everything else were equal, the decision of which would be better would depend on your income tax bracket in retirement as compared to what it is now. If you expected the bracket to be lower, a traditional IRA/401(k) likely would provide tax savings. If you expected the bracket to be higher, the Roth might be the better choice.

Flexibility on distributions and contributions

With a traditional IRA, you must start taking withdrawals no later than April 1following the year in which you reach age 70¹/₂. And, you may no longer make contributions starting in the year in which you reach age 70¹/₂. There are no such restrictions on Roth IRAs.

Although a Roth 401(k) does have a required minimum distribution, by rolling the account into a Roth IRA you’d have the flexibility of not having to make distributions. By using a Roth 401(k)/Roth IRA combination, you’d also be able to avoid the income tax due on the distribution that would be required if the funds were in a traditional 401(k)/IRA.

Distribution to heirs on your death

Although the distribution rules with respect to a traditional 401(k)/IRA that is inherited can create unwanted income tax consequences, distributions from a Roth 401(k)/IRA aren’t subject to income tax. Though there are required minimum distributions for all inherited accounts mentioned, the timing of the distribution and the required amounts will depend on various factors, such as whether the account is an IRA or 401(k), who is the beneficiary, and whether your death was after the required beginning date of distributions. Plus, as long as funds are in a Roth account, they grow (and can be distributed) free of any income tax consequences.

Rolling a traditional IRA into a Roth IRA

Whether you’ve made direct contributions or rolled 401(k) accounts into a traditional IRA, it may be advantageous to convert your IRA to a Roth IRA. Historically, your income may have been too high to allow you to make the conversion, but, under the Tax Increase Prevention and Reconciliation Act of 2005, the $100,000 income limitation for a conversion will be eliminated in 2010. Thus, in 2010, an individual of any income level can make a Roth conversion.

Once you’re eligible, the question is whether it makes sense. Suppose, for example, you have a $1 million IRA. By rolling the entire $1 million into a Roth IRA in the same year, you’ll be faced with a federal tax of nearly $350,000 (assuming the current top rate of 35% is in effect), plus any state tax associated with the conversion. And, if you happen to roll the funds in 2010, the law provides that the income — absent certain circumstances — will be reported 50% in 2011 and 50% in 2012, allowing you to somewhat defer the tax impact.

The ability to do a Roth conversion also is a potential “deathbed” strategy. Let’s say you roll your IRA into a Roth IRA and then die shortly thereafter. Your heirs receive a $1 million IRA, but, because of the $350,000 tax liability, your incremental estate tax is based on only the net amount of $650,000. Thus, at today’s highest marginal bracket of 46%, the estate tax related to the IRA is, on a net basis, only $299,000 (rather than the $460,000 that would have been assessed on the $1 million IRA had it not been converted). The related income tax, in effect, reduced your estate tax liability by $161,000. You receive a subsidy for rolling the traditional IRA into a Roth IRA. Of course, in 2010 this won’t be an issue because the estate tax is scheduled to be repealed for that year.

Account for the differences

Bear in mind that there are important differences with respect to traditional and Roth IRAs, as well as traditional and Roth 401(k)s. If you’re eligible to make contributions to

any or all of the available accounts, consider which is best for your circumstances — not just today but also for generations to come.

Chart: IRA contribution phaseout schedule