Conventional wisdom suggests that inheriting a Roth IRA is always better than inheriting a traditional IRA. In the case of the former, the distributions are tax-free and in the case of the latter, distributions are taxed as ordinary income.
But experts say IRA account owners — especially those who wantto convert their accounts intoRoth IRAs — might want to reconsider what’s better to receive: tax-free income or taxable income.
“A Roth is tax-free, and so people naturally assume inheriting a tax-free account is better than inheriting a pretax IRA,” says Michael Kitces, author of the Nerd’s Eye View blog. “Which, strictly speaking, is ‘true’ but only when you ignore the taxes you paid upfront to create that Roth, which is a real cost and should be included.” It’s possible, he says, the original IRA owner may pay more in taxes to create that Roth than the beneficiary ever would have paid by just inheriting a pretax IRA.
Traditional IRA owners have to pay taxes on the distribution that’s being converted into a Roth IRA
How do I find a Medigap plan that covers me outside the U.S.?
Others also say inheriting a Roth IRA isn’t always the best option. “We’ve always been on the ‘show me’ side when it comes to theRoth, especially in the case of upfront conversions, where the burden of proof is even greater,” says Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research in San Francisco.
So what’s the best way to decide whether to convert a traditional IRA to a Roth IRA before passing down assets to loved ones and heirs?
“The basic rule forRothIRAcontributions/conversions remains true no matter who is making the withdrawal — the original owner or beneficiary,” says Spiegelman. While there may be special situations, “ARothmakes sense when the income tax bracket at the time of distribution is the same or higher than at the time of contribution/conversion.”
Others also say it’s a matter of tax rates. “You should pay your taxes whenever your rates are lower,” says Kitces. And John Kilroy, a certified public accountant in the Philadelphia area, says, “TheRoth decision is solely and completely a tax-motivated one.”
That said, here are the basic rules of thumb:
• If kids’ rates are higher, bequeath a Roth. Kitces gave this example: If the kids’ tax rates are higher — they are, for example, business owners, lawyers, doctorsand the like — then let the parents convert at their lower tax rates and leave the kids a Roth.
• If parents’ rates are higher, bequeath a traditional IRA. If, on the hand, the parents’ tax rates are higher — they have, for example, significant net worth and the kids are 20-somethings struggling to just get a job at all and are in bottom tax brackets — Kitces recommends just leaving them a “big pretax account and let them liquidate themselves at their own tax rates.”
• If tax rates are equal, bequeath a Roth.Kitces says there’s a slight bias in favor of doing the Roth conversion, primarily to avoid required minimum distributions (RMDs) that apply to the parents while alive, which would boost their tax bill. “It’s actually a minor benefit for most, but better than nothing if tax rates are equal anyway,” says Kitces.
• Caveats. To be fair, these general rules of thumb make a few assumptions. For one, they assumethat parents don’t actually need the money and the IRA is earmarked for inheritance in the first place. “Otherwise, it’s about the parents’ future tax rates when they’ll need the money, not the kids’ rates,” says Kitces.
And two, they assumethere’s no state estate tax, which can complicate the issue, says Kitces.
In the case of a taxable estate —one that exceeds the exemption limit of $5.45 million per individual —Spiegelman says aRoth conversionmaystill make sense insofar as the reduction in estate taxes results in greater net inherited assets irrespective of relative income tax brackets.
Should we convert to a Roth IRA? Look at big picture on taxes
Other issues worth noting:
- No crystal ball. No one can predict the future of our tax system, says Kilroy. Given that, he says it's best to convert some traditional IRAs into Roths over time, but not all of the assets. That way, beneficiaries would inherit both traditional and Roth IRAs.“The erratic nature of our tax system increasingly suggests to me that having all retirement eggs in either basket (pretax orRoth) is not a good idea.”
- No one gets it right. “Parents often misjudge the tax bracket of their beneficiaries,” says Joseph Clark, a managing partner with The Financial Enhancement Group in Anderson, Ind. “In my practice the parents are usually in a lower bracket at retirement than their kids. Again, it is all being tax conscientious.”
- Don't sweat it. “For 99% of the population, the discussion is probably moot,” says Spiegelman. “For most folks, an inheritance in any form would be a blessing, especially if it’s tax-free.”
For more read, When A Roth IRA May Actually Be A Terrible Asset To Inherit.
Robert Powell is editor ofRetirement Weekly, contributes regularly to USA TODAY,The Wall Street JournalandMarketWatch. Got questions about money? Email Bob at rpowell@allthingsretirement.com.
