For most of us, it’s hard to imagine not needing every penny of our retirement savings to support our own selves in our later years. However, for a lucky few, a portion of retirement savings will be passed on to their (hopefully eternally grateful) children.
For those lucky few, the Roth IRA has the benefit of providing tax-free income to the next generation for their whole lives.
First, a word about inheriting IRAs. Well, several words, actually. Ed Slott, the king of IRA rules, has a whole book about this called The Retirement Savings Time Bomb and How to Diffuse It, but this being a blog and not a 300+ page book, I’ll just hit the highlights.
If spouses inherit an IRA account, they can incorporate the account their own retirement savings as if it were always theirs to begin with. This is cool because the account can continue to grow tax-deferred (Traditional IRA) or tax-free (Roth IRA) until the surviving spouse reaches retirement age. This is especially nice for that much younger trophy wife/husband.
However, if your kids, brother, parents, friends, pet ferret, or anyone other than your spouse inherits your IRAs, they must start taking payments from those accounts by December 31st of the year after your death. The payments are determined by the account value divided by number of years the IRS thinks that beneficiary will live. Why is this required? Because the IRS doesn’t want tax advantaged accounts passed down over the generations indefinitely.
So, how does using a Roth IRA help? Well, it’s just swell for your kids, brother, etc. to get that income tax-free. What if your son inherits your Traditional IRA in the prime of his career? The forced IRA income from your estate will be taxed at a high income tax rate, therefore diminishing the inheritance. If a Roth IRA is passed down, the income from that IRA won’t be added to your rich son’s income tax, therefore preserving more of the after-death gift from taxes.
Now, there are plenty of people who don’t give a rat’s whiskers how much their kids inherit from them and that is just fine. If that is your feeling, then don’t pay taxes yourself (i.e. do Roth conversions) to save your inheriting kids from paying taxes later.
As with so much of estate planning, there is no right or wrong answer. A lot has to do with your personal preferences, beliefs, and values.
And that does it for this week! Next week, we’ll talk about Reason #3 that people use Roth IRAs – managing Minimum Required Distributions.
