Beware Leaving a Roth for Heirs
Idea Makes Sense, but New IRA Rules Could Make the Decision Harder
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.
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," says Jamie Hopkins, a professor in the retirement income program at the American College in Bryn Mawr, Pa.
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.
"If there's no stretch IRA, it doesn't pay for an older person to convert to a Roth," says Ed Slott, founder of IRAHelp.com. "Why should someone 60, 70 years old, who's mainly doing it for their beneficiaries, pay a tax when the deferral rate after they die is limited to five years?"
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.
"The interesting thing about a Roth is that on its surface it always sounds really terrific—until you run the numbers," says Nancy Skeans, a partner and managing director of personal financial services at Schneider Downs Wealth Management Advisors in Pittsburgh. 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," says Michael Kitces, publisher of the Kitces Report and a partner at Pinnacle Advisory Group.
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. "We've seen big Roth conversions where someone converts a $3 million IRA all at once. Now we're at a 39.6% tax rate," Mr. Kitces says. "You just blew up a whole bunch of family wealth."
Still, for retirees who are enjoying low tax rates, one or a series of conversions can make sense. "You can do that tax calculation every year and say, 'How much can I bring in from the IRA on an annual basis to get it in at a lower tax rate than the children would pay?' " Ms. Skeans says.
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.
"I'm pretty sure your struggling-artist child isn't going to be in a 39% tax bracket soon," Mr. Kitces says.
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.