How a Roth Conversion Affects Your Heirs


IRAs are primarily meant for retirement. That goes for the traditional kind, or TIRA, as well as the tax-free Roth.

But some lucky investors have more than they need for retirement, or hope to. They expect to pass assets to children or other heirs. If so, this becomes a factor in deciding whether to keep your TIRA or convert to a Roth.

In general, the Roth treats heirs better, allowing for tax-free withdrawals and more years of tax-free compounding.

People who inherit a TIRA are required to begin withdrawals at one point or another, and must pay income tax on withdrawals attributable to investment earnings and tax-deductible contributions made by the original investor.

A person who inherits from a spouse faces the same requirement as the original account holder — to begin withdrawals after turning 70 ½. Other beneficiaries must start taking money out the year after the original account holder died.

People who open Roths for themselves, or who convert TIRAs into Roths, are never required to make withdrawals. Nor are spouses who inherit Roths. Non-spouse heirs generally have to begin withdrawals within the first five years, but the withdrawals are tax-free. The chief downside is that tax bills will begin to accrue on any withdrawal reinvested in a taxable account.

How does all of this bear on the conversion decision?

Basically, the decision hinges on the same issue that confronts all TIRA investors: tax brackets now and in the future. Because tax must be paid on converted sums, it boils down to paying tax at today’s rates by converting to a Roth, or paying at a future rate by keeping the TIRA.

If the heir is likely to be in a higher tax bracket than you are today, a conversion could make sense. You’d pay at today’s low rate so your heir would not have to pay at a higher rate later. If the heir’s rate is likely to be lower than yours, it probably would make sense to keep the TIRA.

The second key conversion issue: the conversion tax must be paid from some other source, so that the entire TIRA can be moved into the Roth. This is so whether you’re converting for yourself or to benefit an heir.

Estate taxes create another wrinkle. If your estate will be large enough to face an estate tax, money spent on a conversion tax would be removed from your estate, reducing the estate tax. Estate-tax rates have generally been higher than income-tax rates and converting would therefore subject you to a lower tax.

Unfortunately, the estate-tax issue is up in the air. There is no estate tax this year, but old rules may return in 2011, unless Congress comes up with something new. The best you can do is to keep abreast of the issue and then try to factor any new rules into your Roth conversion decision.

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