Think Twice When Leaving A Roth IRA

While leaving money to heirs through a Roth IRA may seem like a great idea as funds can grow tax-free over a lifetime, Roths are not always the best way to pass down wealth.  Whether a conversion is rational depends on tax rates of both the account holder and heirs and whether lawmakers approve proposed rule changes that could eliminate some of the estate-planning benefits of Roths. 

Several proposals in President Obama’s 2015 budget could change the appeal of Roth IRAs.  First, Roth owners would be required to begin taking distributions at age 70 ½ .  The second would end the ability of nonspousal IRA beneficiaries to stretch distributions.  Thus, inherited IRAs would have to be disbursed within five years of the owner’s death.  Whether these proposals become law remain questionable. 

In addition to the potential rules change, there are other issues individuals should keep in mind before converting a Roth to heirs.  Tax rates are a crucial 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.’”  Yet the Roth’s lead is undermined if the beneficiary’s tax rate is lower than the account owner’s. 

See Andrea Coombes, Beware Leaving a Roth for Heirs, The Wall Street Journal, Sept. 7, 2014. 

Special thanks to Jim Hillhouse (Professional Legal Marketing (PLM, Inc.)) and Joel Dobris (Professor of Law, UC Davis School of Law)for bringing this article to my attention.