Do you have an IRA you are thinking about converting to a Roth IRA? There are many benefits to converting. You trade an immediate tax bill for the promise of tax-free earnings and distributions down the road. However, one benefit you may not have considered is the benefit to your beneficiaries. Inheriting a traditional IRA will have very different tax consequences than inheriting a Roth IRA. An IRA conversion to a Roth IRA is really a gift to your beneficiaries.
Consider the following example. Let’s say Gus named his three children as beneficiaries of his three-million-dollar traditional IRA. He never made any nondeductible contributions. When his children take distributions from their inherited traditional IRAs, those distributions will be fully taxable, but not subject to penalty. What if Gus converted his traditional IRA to a Roth IRA more than five years ago? All distributions from the inherited Roth IRAs paid to his children would be tax and penalty-free. That is a very different result.
Traditional IRA Beneficiaries
If you are the named beneficiary of a traditional IRA, you will most likely face income tax consequences. This is because most funds in traditional IRAs are tax-deferred, but not tax-free. Uncle Sam will eventually want his share. Distributions to beneficiaries will be taxable to the beneficiaries in the year taken.
To make matters worse, after the SECURE Act, most non-spouse beneficiaries no longer can stretch distributions over a lifetime but instead will be subject to a 10-year payout period, often with required minimum distributions during the 10-year period. That could mean big tax bills!
Roth IRA Beneficiaries
What if you are the named beneficiary of a Roth IRA? Roth IRAs work very differently. Tax-year contributions and converted funds are always tax-free when paid to beneficiaries. This makes sense because these funds are after-tax funds. The deceased Roth IRA owner has already paid taxes on them. Earnings will be tax-free if the five-year holding period that began with the deceased IRA owner’s first Roth IRA contribution or conversion is met. If not, earnings will be taxable until the five-year holding period has been satisfied. The good news for you is that earnings will not be considered distributed from the Roth IRA until all contributions and converted funds are paid out. The 10% early distribution penalty never applies to distribution to either a traditional or Roth IRA beneficiary, regardless of their age or the age of the IRA owner.
While most non-spouse Roth IRA beneficiaries are also subject to a 10-year payout rule under the SECURE Act, there are no annual distributions required during the 10-year period. That means the entire inherited account could potentially grow tax-free for ten years and then be withdrawn with no taxes owed.
Consider Conversion for Your Beneficiaries
The bottom line is that Roth IRAs are a great deal for a beneficiary. Most distributions will be income tax and penalty-free. Consider a conversion not only for the benefits to you during your lifetime, but also as a gift to your heirs.
By Sarah Brenner, JD
Director of Retirement Education
