Understanding the Tax Consequences of Inheriting a Roth IRA

While many people have a Roth IRA as part of their estate plan, comparatively fewer are aware that a Roth IRA can also be an effective component of an estate plan. Unlike distributions from a traditional IRA, distributions from a Roth IRA are not taxed. Another difference between a traditional IRA and a Roth IRA is that the owner of a traditional IRA must begin taking distributions at age 70 1/2. There is no requirement to take distributions from a Roth IRA for the original owner (or a surviving spouse, who may treat the Roth as his or her own), but there are required minimum distributions for inherited Roth IRAS.

It is possible to convert a traditional IRA into a Roth IRA for your heirs’ benefit. If you do so, you will have a tax bill to pay: federal, and possibly state, income tax on tax-deductible contributions and accumulated earnings. In essence, you have taken two steps: made a taxable withdrawal from the traditional IRA, and then a non-tax deductible contribution to the Roth. If you have the resources to pay this tax bill from assets other than the IRA, you’re doing your heirs and yourself a favor. You will have prepaid income tax on their behalf, avoided paying gift tax or consuming any part of your unified federal gift and estate tax exemption, and reduced your taxable estate by the amount of the tax prepayment.

Before you rush to convert your traditional IRA into a Roth IRA for the benefit of your heirs, there are other tax consequences and distribution rules you should consider.

Should You Leave Your Heirs a Traditional IRA or a Roth IRA?

There are many factors involved in the decision whether to leave your heirs a traditional or a Roth IRA, but in the final analysis, your goal is to maximize the amount that you leave your heirs, while minimizing the amount of taxes paid. This requires an assessment of whether your beneficiary’s tax rate is going to be higher or lower when they receive the IRA than yours is when you fund it.

As a general rule, if your tax rate is lower than your intended beneficiary’s, a Roth IRA is probably the better option; you will pay less in taxes on the contributions than your beneficiary would if they had to pay tax on the distributions of a traditional IRA.

As a general rule, a Roth IRA can be a good option to leave to heirs if your tax rate is lower than that of your beneficiary.

If, however, your tax rate is higher than your intended beneficiary’s, it might make more sense not to convert a traditional IRA into a Roth. This way, you will be spared the tax bill at your higher rate on a conversion, and your beneficiary will pay taxes at his or her lower rate when it comes time to take distributions.

Even if all other factors, such as avoiding required minimum distributions, mitigate in favor of a Roth IRA, a Roth can still be a bad idea. If tax rates at the time of distribution (either to the current owner or to an heir) are expected to be significantly lower than those of the contributor at the time funds are contributed to the IRA, a traditional IRA is probably a better option.

Evaluating Likely Tax Rates for an IRA

Of course, absent a reliable crystal ball, you can’t always know for sure what a beneficiary’s tax rate is likely to be at the time distributions are made. In trying to anticipate whether to leave heirs a Roth IRA or a traditional IRA, consider the following factors:

• Beneficiary’s income from employment and other sources: If the beneficiary is in a lower income profession, and has no other sources of income, then he or she might be in a low enough tax bracket to make a Roth IRA make more sense.
• Other inherited assets of the beneficiary which might bump up his or her marginal tax rate.
• Number of beneficiaries and amount of any required minimum distributions: The more beneficiaries there are, the less burdensome required minimum distributions may be.
• The beneficiary’s state of residence (especially if different than the original owner of the IRA): Last but not least, don’t underestimate the impact of state income tax rates, which can vary considerably. If you live in a state with a high income tax, and your intended beneficiary lives in one with a lower one. that may make a traditional IRA a preferable option.

There are other considerations, of course, if the beneficiary of the IRA is going to be a trust. Trusts can maximize the opportunity for principal to accumulate and extend tax deferral. Whether to convert to a Roth may depend on whether the trust qualifies as a “see-through” beneficiary to stretch the IRA, and whether IRA distributions will accumulate within the trust or flow through to the trust beneficiaries.

Last but not least, all these considerations are founded upon current law. If the law changes, the analysis of whether to leave beneficiaries a traditional IRA, or convert it to a Roth, will change as well. If you’d like to learn more about the advantages and disadvantages of inheriting a Roth IRA, we invite you to contact us. We can work together with your financial and tax professionals to maximize your tax planning opportunities.