The question of whether to convert a traditional IRA to a Roth, can become more complicated as we get older. However, if you plan to leave the IRA to an heir, paying the taxes to convert it now can make sense. The Roth IRA can grow tax-free over your lifetime, as well as that of your heir. A study by the Vanguard Group shows that in some situations, converting to a Roth can mean a larger legacy for your heirs, than if you passed down a traditional IRA.
Kiplinger’s article, “Roth Conversions May Be Boon for Heirs,” explains that the study was focused on Roth’s beyond retirement. The Vanguard's study considered a 65-year-old with a 40-year-old non-spouse beneficiary. The investor has a $100,000 traditional IRA and a $28,000 taxable account, with both earning the same 6% annual rate of return. Both the IRA owner and the heir are in the 28% tax bracket. The Vanguard study assumes the beneficiary inherits the accounts after 20 years.
If the investor keeps the traditional IRA and, upon reaching age 70, reinvests all required distributions in the taxable account, when the heir inherits, he will need to take annual RMDs (required minimum distributions) over his own life expectancy and reinvest the after-tax amounts into the taxable account. When the heir inherits the traditional IRA and taxable account, he receives $318,799. Ten years later, that increases to $536,850.
However, if the investor had converted the IRA to a Roth at age 65, the heir's total inheritance could be worth $21,000 more at inheritance. Ten years later, it could be worth up to nearly $66,000 more. With a Roth, the original owner isn’t subject to RMDs. If you use non-IRA dollars for the conversion tax bill, you can transfer more money. Vanguard’s research put the investor and her heir in the same tax bracket. By converting, you’re taking an asset with an embedded tax liability and prepaying that tax. Therefore, if the investor's tax rate is lower than the heir's, the conversion could be even more advantageous to the heir. But the inverse is also true—if the heir is in a lower bracket, the advantage may be less or nothing.
Note that the conversion scenario assumes the IRA owner pays the conversion tax bill with funds in the taxable account and not from the IRA. That makes a difference, because if the tax had been paid with IRA money, the advantage of the conversion after 30 years would be sliced to about half.
Paying the tax bill with outside funds leaves more money in the tax shelter, supercharging its growth and making it more of a bargain for the taxes paid. In addition, Roth RMDs are tax-free, so he can fully reinvest the withdrawals and the money still in the inherited Roth continues to grow tax-free over his own lifetime.
Reference: Kiplinger (March 2017) “Roth Conversions May Be Boon for Heirs”