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 ½- 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.