Should you convert a traditional IRA to a Roth? It seems like a stickier question the older you get. But if you plan to leave the IRA to an heir, paying the tax bill to convert now can make sense because the Roth can grow tax-free not only over your lifetime, but your heir's lifetime, too. A study by the Vanguard Group shows that in some circumstances, converting can result in a larger legacy for your loved one than if you passed on a traditional IRA.
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"We really were trying to think about Roths beyond retirement," says Maria Bruno, a senior investment strategist for Vanguard and a co-author of the study. In Vanguard's study, the authors considered a 65-year-old with a 40-year-old nonspouse beneficiary. The investor has a $100,000 traditional IRA and a $28,000 taxable account. Both accounts earn the same 6% annual rate of return, and both the IRA owner and the heir are in the 28% tax bracket. Vanguard's study assumes the beneficiary inherits the accounts after 20 years.
In one scenario, the investor keeps the traditional IRA and, upon reaching age 70, reinvests all required distributions in the taxable account. When the heir inherits the traditional IRA, he takes annual RMDs over his own life expectancy and reinvests the after-tax amounts into the taxable account.
At the time the heir inherits the traditional IRA and taxable account, he receives a total of $318,799. Ten years later, that wealth climbs to $536,850. Not bad.
But if the investor had converted the IRA to a Roth at age 65, the heir's total inheritance could be worth more than $21,000 extra at the time of inheritance and 10 years later could be worth up to nearly $66,000 more. With a Roth, Bruno says, the original owner is "not subject to required minimum distributions, and if you use non-IRA dollars [for the conversion tax bill], you can transfer a greater amount of wealth."
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For simplicity's sake, Vanguard assumes the investor and her heir have the same tax rate. By converting, Bruno says, "you are taking an asset with an embedded tax liability and prepaying that tax." If the investor's tax rate is lower than the heir's, the conversion could be even more advantageous to the heir. If, however, the heir is in a lower bracket, the advantage may be diminished, or even disappear. (Keep this in mind as the new administration contemplates lowering income tax rates as part of a major tax reform push.)
Paying the Conversion Tax Bill
The conversion scenario outlined above assumes the IRA owner pays the conversion tax bill with funds in the taxable account rather than dipping into the IRA. That makes a big difference. If the tax had been paid with IRA money, the advantage of the conversion after 30 years would be cut nearly in half.
Paying the tax bill with IRA funds would leave just $72,000 in the Roth, plus the $28,000 taxable account. The Roth lets the IRA owner avoid RMDs during her lifetime. Twenty years later, her heir inherits both accounts, and he must take tax-free RMDs from the Roth over his life expectancy. At inheritance, he receives $329,924, about $11,000 more than in the traditional IRA scenario. Ten years later, his wealth is about $36,000 more, at $572,903. Pretty good.
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But the results are even better if the IRA owner pays the Roth conversion tax bill with the $28,000 in the taxable account. When the heir inherits the Roth 20 years later, he receives about $10,000 more than if the tax bill is paid with IRA funds. The heir reinvests his tax-free RMDs in a taxable account, and 10 years later the two accounts hold $602,461 -- nearly $30,000 more than if IRA money is used to pay the tax.
Paying the tax bill with outside funds keeps more money in the tax shelter, supercharging the growth and giving you a bigger bang for your tax bucks. "It's the better way to go," Bruno says.
But it's the Roth's benefits for the heir that also pump up his inherited wealth. Tax-free RMDs mean he can fully reinvest the withdrawals. And the money still sitting in the inherited Roth continues to grow tax-free over his own lifetime.
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Copyright 2017 The Kiplinger Washington Editors