ROTH IS HEIRS’ BEST FRIEND, MANY PLANNERS NOW SAY: IT’S A "FOREVER TAX-FREE ACCOUNT" — UNLESS THE RULES CHANGE

Roth IRAs have one obvious shortcoming: Many of the older people who could benefit from converting to them have adjusted gross incomes over the $100,000 limit for individuals.

On the other hand — and it’s a very large hand — planners have come to realize that Roths, while not tax-deductible, offer perpetual tax-free growth of capital.

Holders never have to take distributions. And when the Roth holder dies, monies taken out of the account to pay estate taxes are not subject to income tax, resulting in a substantial savings over traditional IRAs.

Even the eligibility issue may soon be addressed. A provision in the Senate version of the bill restructuring the Internal Revenue Service calls for excluding minimum distributions from traditional IRAs from being used to calculate adjusted gross income. As many as 170,000 people could take advantage of the rollover provision in the five years after 2005, the year the provision would take effect, says a spokeswoman for Senate Finance Committee Chairman William Roth, R-Del., who sponsored the provision.

Says James Shambo, president of Lifetime Planning Concepts PC, a Colorado Springs, Colo., firm that supervises $7 million in assets: “The main advantage (of a Roth IRA) is a forever tax-free account, unless Congress changes the rules on us again.

“You can have a fully diversified portfolio and still be tax free. We’ve never had that. Before, if you wanted tax-free (money) you had to do municipal bonds, or a full growth portfolio.”

Frank Presson, president of Presson Financial Associates LLC in Tucson, Ariz., says he is persuading clients to convert to avoid the minimum distribution rules. Mr. Presson manages about $6 million. “It turns out to be a nice estate-planning tool,” he says, because the money can be passed on without income tax payments to spouses and later to other heirs. “This thing just keeps going forever,” he says.

Taxes can be spread out over four years for conversions made this year. Money must be kept in Roth IRAs for at least five years to avoid penalties.

No figures are available on how many people are expected to convert traditional IRAs to Roths, but the vast majority of filers are eligible. Some 112.9 million of the 118.2 million tax returns filed in 1995, the latest year for which figures are available, had adjusted gross incomes of under $100,000, according to Internal Revenue Service figures.

it’s a gift

Roths have a gentler tax bite when a holder dies. Joseph Falanga, estates and trusts partner with New York CPA firm Goldstein Golub Kessler & Co. PC, says “with a regular IRA, if you have to pull money out of the IRA to pay the estate tax, you have to pay income tax on the IRA.” But Roth IRA funds used to pay estate taxes are free of income taxes.

Stuart Kessler, senior tax partner with the firm and chairman of the American Institute of Certified Public Accountants, estimates that savings could be substantial at death: “When children get the regular IRA, anywhere from 60% to 85% of the money is gone to taxes.” Maximum income tax rates are 39.6%, while estate tax rates are as high as 55%.

Mr. Kessler estimates that income and estate taxes of $1.2 million to $1.75 million would have to be paid at death for a $2 million traditional IRA, while estate taxes on a $2 million Roth IRA would probably be between $1 million and $1.15 million.

Baltimore mutual fund company T. Rowe Price Associates Inc. is among the proponents of using Roth IRAs for estate planning. Christine Fahlund, a certified financial planner there, says many people over 65 are eligible to convert to Roths or can employ various techniques to reduce adjusted gross income to become eligible.

“Especially when you retire you may very well be under the $100,000 limit, or you may be able to manipulate your investment income so you’re under $100,000,” she says.

Another distinct advantage is that Roth IRA holders can change their beneficiaries and their minimum distribution schedules at any time, while traditional IRA holders are locked into distribution schedules after age 701/2.

Ms. Fahlund says the traditional IRA feature has caused problems for many couples, because wives typically need to have distribution schedules based on their life expectancy, rather than on their children’s. After the second spouse dies, Roth IRAs can be annuitized by heirs, she says.

But some planners balk at the income limits on conversions. “Where it makes sense to convert is in a set of very constrained circumstances,” says Eleanor Blayney, principal of Sullivan Bruyette Speros & Blayney, a McLean, Va., a planning firm with $360 million under management.

In addition to the $100,000 income limits, she says, conversions should be made only when an IRA holder’s tax rates are less than what they would be when they withdraw funds from a traditional IRA.

“That’s not a likely scenario. When you convert the IRA, that goes into income. That in and of itself makes it less likely that you can convert at a lower bracket than you could ultimately withdraw the IRA.”

But despite the shortcomings, Ms. Blayney says estate planning “may be one of (the Roth’s) most compelling uses. . . In essence it does become a way of enhancing the amount that passes to your children. It’s like you’re paying the taxes today. That becomes a gift to them. That doesn’t necessarily improve your situation, but it could improve your beneficiaries’ situation.”