Understanding the Tax Consequences of Inheriting a Roth IRA

August 5, 2016

Passing down a Roth IRA can seem like a good idea, but it doesn’t always make the most sense. Before converting a traditional IRA into a Roth IRA to benefit your heirs, you should consider the tax consequences.

Earnings in a traditional IRA generally are not taxed until they are distributed to you. At age 70 1/2 you have to start taking distributions from a traditional IRA. Contributions to a Roth IRA are taxed, but the distributions are tax-free. You also do not have to take distributions on a Roth IRA.

Leaving your heirs a tax-free Roth IRA can be used as part of an estate plan.   However, in figuring out the best type of IRA to leave to your beneficiaries, you need to consider whether your beneficiary’s tax rate will be higher or lower than your tax rate when you fund the IRA. In general, if your beneficiary’s tax rate is higher than your tax rate, then you should leave your beneficiary a Roth IRA. Because the funds in a Roth IRA are taxed before they are put into the IRA, it makes sense to fund it when your tax rate is lower. On the other hand, if your beneficiary’s tax rate is lower than your tax rate, a traditional IRA might make more sense. That way, you won’t pay the taxes at your higher rate; instead, your beneficiary will pay at the lower tax rate.

Regardless of which IRA you pass on to your heirs, remember that your IRA is part of your taxable estate, so it can be subject to estate taxes if your estate is over the estate tax exemption ($5,450,000 in 2016).

Also bear in mind that the above is based on the tax rules as they now exist (August 2016).  Future tax rules regarding inherited IRAs may change, making certain strategies more or less advantageous.    

For information on what to do with an inherited IRA.

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What Is Undue Influence?

Saying that there has been “undue influence” is often used as a reason to contest a will or estate plan, but what does it mean?

Undue influence occurs when someone exerts pressure on an individual, causing that individual to act contrary to his or her wishes and to the benefit of the influencer or the influencer’s friends. The pressure can take the form of deception, harassment, threats, or isolation. Often the influencer separates the individual from their loved ones in order to coerce. The elderly and infirm are usually more susceptible to undue influence.

To prove a loved one was subject to undue influence in drafting an estate plan, you have to show that the loved one disposed of his or her property in a way that was unexpected under the circumstances, that he or she is susceptible to undue influence (because of illness, age, frailty, or a special relationship with the influencer), and that the person who exerted the influence had the opportunity to do so. Generally, the burden of proving undue influence is on the person asserting undue influence. However, if the alleged influencer had a fiduciary relationship with your loved one, the burden may be on the influencer to prove that there was no undue influence. People who have a fiduciary relationship can include a child, a spouse, or an agent under a power of attorney. For more information on contesting a will, go here.

When drawing up a will or estate plan, it is important to avoid even the appearance of undue influence. For example, if you are planning on leaving everything to your daughter who is also your primary caregiver, your other children may argue that your daughter took advantage of her position to influence you. To avoid the appearance of undue influence, do not involve any family members who are inheriting under your will in drafting your will. Family members should not be present when you discuss the will with your attorney or when you sign it. To be totally safe, family members shouldn’t even drive or accompany you to the attorney’s office. You can also get a formal assessment of your mental capabilities done by a medical professional before you draft estate planning documents. For more information on preventing a will contest, go here.

July 14, 2016

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