What’s the best strategy for transferring my wealth to my heirs through an IRA?

Converting your traditional IRA to a Roth IRA can offer some real benefits if you plan to use your IRA to provide income for your heirs. And these benefits are now available to everyone with a traditional IRA because the $100,000 Modified Adjusted Gross Income (MAGI) limit for Roth IRA conversions has been eliminated.

Let’s look at why a Roth IRA conversion might be a good strategy for transferring wealth to your heirs.


A Wealth Transfer Strategy

The owner of a traditional IRA is subject to required minimum distributions (RMDs), which are designed to deplete the account over the owner’s lifetime. A Roth IRA, on the other hand, is not subject to RMDs. By converting a traditional IRA to a Roth IRA, you avoid required distributions, allowing you to keep more assets in this tax-free account for your heirs.

The chart below compares the results of “stretching” a traditional IRA and a Roth IRA. It assumes the IRA owner does not need the IRA for income and all RMDs are reinvested in a taxable account.

Front of Chart

To convert or not convert a $1000000 traditional IRA

As the chart shows:

 

In the traditional IRA example, half of the assets are passed on to heirs outside of the IRA in a taxable account, as a result of required owner RMDs.
Regardless of whether a beneficiary inherits a traditional IRA or a Roth IRA, he or she must take RMDs, which are calculated based on the beneficiary’s life expectancy. The younger the beneficiary – and therefore the longer the potential “stretch” period – the more important tax-free growth and distributions become, and the greater the advantage of the Roth IRA.
When considering a Roth IRA conversion, you also need to consider your tax bracket relative to your beneficiary’s. If your tax bracket is lower than your beneficiary’s will likely be, a Roth IRA conversion can be even more valuable since it allows your beneficiaries to skip these future high tax bills.
When you convert a traditional IRA to a Roth IRA, the conversion amount is taxable. If you pay the tax with money from the IRA, the amount withheld for tax counts as a distribution and an additional 10% tax penalty may apply to it if you’re under 59 1/2. So it’s generally better to pay the tax from an outside, less tax-efficient source.
In these hypothetical examples, the converted Roth IRA has done better due to the combined power of tax-deferred compounding and tax-free distributions.

 


A Comparison to Traditional IRAs

Back of Chart

Similarities and differences between traditional and roth IRAS

As the chart shows:

 

Money you contribute to a Roth IRA has already been taxed so it can subsequently be withdrawn tax free at any time. (Investment earnings in the Roth IRA cannot be withdrawn tax free until you are at least age 59 1/2 or unless you qualify for one of the other exceptions to the 10% premature tax penalty.) Additionally, money converted from a traditional IRA into a Roth IRA can be withdrawn penalty free after five years. The net effect of these rules is that a Roth IRA provides tremendous flexibility in accessing your money before you reach age 59 1/2

 

Investing involves risk, including possible loss of principal.

The information provided is not intended to be tax advice.  Investors should be urged to consult their tax professionals or financial advisors for more information regarding their specific tax situations.

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