The advantage of a traditional IRA or Roth IRA when it comes to inheritance comes down to the circumstances.
Since distributions from a Roth IRA are tax-free while a traditional IRA is not, it is understandable that most people consider the Roth IRA has the advantage in inheritance since not having to pay taxes always trumps having to pay them.
However, as the USA Today pointed out in a recent article entitled “Inheriting a Roth IRA isn’t always best news,” when it comes to IRAs things are not as simple as they seem.
What is often ignored is that taxes have to be paid when an IRA is converted from a traditional one to a Roth IRA.
Consequently, Roth IRAs do not magically shield the money from taxes. The money is just taxed at a different time.
While it still might seem better strictly from the perspective of the person inheriting the IRA (if he or she is not the one who must pay the taxes upon conversion), that is not necessarily true if the IRA is smaller as a result of converting it.
The general rule of thumb is that if the person who will inherit the IRA has a higher tax rate than the person who currently holds it, then a Roth IRA is better. Conversely, if the inheritor has a lower tax rate, then it is generally better to keep it as a traditional IRA.
What if the tax rates for the current owner and the original inheritor are the same?
Then a Roth IRA is better. Unfortunately, it still is not that simple.
Since circumstances dictate which IRA (Roth or traditional) has the advantage, it would be beneficial to consult an estate planning attorney before making your decision.
Reference: USA Today (Jan. 20, 2016) “Inheriting a Roth IRA isn’t always best news“
