It is not often that Congress gives out a tax break that is so generous that is seems like it must have been a mistake. But thanks to two recent changes in the tax code, investors with large 401(k) or IRA accounts can now turn those into completely tax-free income for their grandchildren’s lifetimes.

The Roth IRA has always allowed gains to be withdrawn tax-free. So, the Roth IRA has always been the first choice among retirement assets to pass on to your heirs. Last year, Congress lifted the restriction that prevented families with incomes over $100,000 from converting a 401(k) or traditional IRA to a Roth IRA.

Take Advantage of Tax Laws While They Last!

In addition, late last year, Congress raised the amount that can be given to grandchildren, tax free, to $5 million. (This amount would have dropped to only $1 million before Congress stepped in at the end of 2010). The new $5 million limit is set to expire in 2013 if Congress does not extend it and there is much debate about whether this amount should be lowered to try to balance the federal budget. So, this favorable combination of tax breaks may not be around long.

Turn $100K Into $8M!

To see how powerful these tax changes are, assume you were to convert a traditional IRA of $100,000 to a Roth IRA and name a grandchild as the beneficiary.  Under the Roth rules, the grandchild would have to take the required minimum distributions, but those distributions could be stretched out over his (much longer) life expectancy. The unused assets left in the Roth could continue to grow tax free.  Assuming that the grandchild inherited the Roth IRA when he was only one year old, he has an 81.6 year life expectancy. If your grandchild gets an average annual return of 8 percent, then your $100,000 gift would result in an inheritance to your grandchild of $8 million – completely free of estate tax, gift tax and capital gains tax.

The Fine Print

Don’t forget that when you convert to a Roth IRA, you have to pay income taxes on the assets that are moved into that account.  But if you have decades of appreciation ahead of you, the tax bill you pay now may be a small price for the tax-free benefits you can leave to your heirs. Naturally, we would encourage you to consult your accountant, your financial planner and your estate planning attorney before making a final decision about whether a conversion makes sense for you.

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