Leaving money to children or other heirs through a Roth
individual retirement account may sound like a great idea—the funds essentially
can grow tax-free over your lifetime and theirs. But before you rush to convert
all or part of a traditional retirement account to a Roth for your loved ones,
take a closer look. Roths aren't always a good way to pass down wealth, experts
say. Whether such a conversion makes sense depends heavily on tax rates—of both
the account owner and heirs—and whether lawmakers approve proposed rule changes
that could eliminate some of the estate-planning perks of Roths.
What Could Change
Many people use Roths for bequests because account holders
don't have to start taking distributions at age 70½ as they do with traditional
IRAs. The money can sit untouched and grow tax-free throughout the owner's
lifetime—a big plus for those who don't need the assets to live on. And while
those who inherit any type of IRA must start taking distributions immediately,
they are permitted to stretch out those payments over their lifetime, allowing
the bulk of a Roth account to continue growing tax-free.
Two proposals in President Obama's 2015 budget, if approved,
would change all that.
The first would require Roth owners to start taking
distributions at age 70½. If that happens that asset pool might be pretty much
wiped out by the time I get to leave anything to my heirs.
The second would end the ability of nonspousal IRA
beneficiaries to stretch distributions. Instead, inherited IRAs would have to
be disbursed within five years of the owner's death. (Certain beneficiaries
would be exempt.)
That proposal, if enacted, would reduce the estate-planning
benefits of Roths. Contributions to Roths are made with after-tax money, while
withdrawals are tax-free as long as certain rules are met. The opposite is true
of traditional IRAs: Contributions are pretax, and withdrawals are taxed. As
such, the owner of a traditional IRA pays a hefty upfront tax bill to convert
to a Roth.
Whether these proposals become law remains to be seen.
To Convert or Not
In addition to the potential rules changes, there are other
issues people need to consider before converting to a Roth to benefit heirs,
experts say.
Tax rates—what you pay at the time of conversion compared
with what you or your heirs would pay on distributions from a traditional
IRA—are a critical part of the equation. If your tax rate when you convert is
the same as the rate you or your heirs would pay on distributions from your
traditional IRA, the decision is easy: Roths have a slight advantage. At the
time of conversion, you're paying the tax from a tax-inefficient bank or
brokerage account, and compounding future growth in a fully tax-efficient
account.
But the Roth's lead is trumped if the beneficiary's tax rate
is lower than the account owner's, he says. For example, if you convert to a
Roth in California, which levies an income tax, and leave the account to a
child in Texas, where there is no state income tax, the Roth advantage is
easily overwhelmed.
If your tax rate is higher now than your children's would be
when taking distributions from a traditional IRA, a Roth conversion
unnecessarily eats into your children's inheritance. Still, for retirees who are enjoying low tax
rates, one or a series of conversions can make sense.
Getting a handle on future tax rates isn't always easy. But
if there are big differences in tax rates between you and your heirs due to
career choices or other reasons, it isn't difficult.
Meanwhile, the Supreme Court recently decided that inherited
IRAs aren't protected from a beneficiary's creditors, so those worried about
their children's ability to avoid bankruptcy might look to a trust or non-IRA
vehicle for bequeathing assets.
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