When we write about IRAs in this space, we typically talk about them in terms of how they work during your working and retirement years. However, for many of our clients, their IRAs have a dual-purpose. They may be a source of income in retirement, but they are also a legacy planning tool that they want to leave to their children.
If you have both a traditional and a Roth IRA and legacy planning is an important goal you have, you may be wondering which type of IRA is better to leave your children.
An Overview of IRAs
Before we delve into the decision surrounding IRAs and legacy planning, it's important to discuss how each type of IRA-traditional and Roth-works. Traditional IRAs are funded with pre-tax dollars, meaning you may get a tax deduction for the amount you contribute. Eligibility for the tax deduction hinges on your income and whether you have access to a retirement plan through your employer.
The money inside grows on a tax-deferred basis. Any distributions made from a traditional IRA are taxed at your regular income tax rate. Once you reach age 70.5, you'll be mandated to begin taking required minimum distributions from your traditional IRA every year until you die.
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Roth IRAs are funded with after-tax dollars, meaning you don't get a tax deduction when funding a Roth. The money potentially grows tax-free and you'll pay no taxes on qualified distributions. Unlike a traditional IRA, Roth IRAs currently have no RMD requirements, meaning you can keep those assets inside of a Roth IRA for as long as you are alive.
Both IRAs have an annual contribution limit of $5,500, and those who are 50 or older can contribute an extra $1,000 each year. In order to take distributions from your IRA without penalty, you must wait five years or until you reach age 59.5, whichever is longer. One exception to this rule is that you can withdraw contributions made to a Roth IRA at any time without penalty, but the five year/age 59.5 requirement does apply to Roth IRA earnings. Withdrawals prior to age 59.5 or prior to the account being open for five years, whichever is later, may result in a 10 percent penalty tax.
Which Type of IRA Should You Leave Your Children?
The answer to this question ultimately boils down to whether you want to pay the tax bill on your traditional IRA or if you'd like to have your kids pay the tax bill on those tax-deferred dollars.
It's generally less favorable for your children to receive a traditional IRA because they'll be inheriting the tax bill on those assets. Plus, when someone inherits a traditional IRA, they'll have to take RMDs, although the dollar amounts of those RMDs are based on the beneficiary's life expectancy, meaning that they'll likely be relatively small.
Because there are no taxes on qualified distributions from a Roth IRA, there's no tax bill that your beneficiaries inherit when receiving an inherited Roth IRA. However, much like the traditional IRA, beneficiaries will also have to take RMDs from the inherited Roth IRA, although those RMDs are tax-free.
If you want to leave the largest legacy for your children and you're able to pay the taxes on the traditional IRA during your own lifetime, you may want to leave them the Roth IRA. Alternatively, if you need a source of tax-free income in retirement, then you may opt to instead leave the traditional IRA to your children.
In either situation, leaving an IRA to your children is a tremendous gift. Considering all the factors, including the tax implications for each party, will help ensure it's a win-win for everyone involved.
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This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax adviser.
Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of "Your Money" on KLKS 100.1 FM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com . Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment adviser. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.
