Many retirees hold both a tax-free Roth IRA and a tax-deferred account, such as a traditional IRA or a 403(b). And it's now a mantra among many financial advisers that the Roth is the better account to leave to your children because they can take tax-free withdrawals over their lifetimes.
But this may not always hold true. Your children could end up with a bigger inheritance if you tap the Roth for your own expenses and leave your traditional IRA to them, even though they will pay income tax on each withdrawal. The deciding factor: your tax rate versus your beneficiary's rate, according to a recent study in the
The general rule of thumb, the researchers found, is that a child who has a lower tax rate than the parent will get a bigger pot of money if he gets most or all of the inheritance from the traditional IRA. If the child has a higher tax rate than the parent, the heir will do better getting most or all from the Roth. "The widow and heir can maximize their joint after-tax amount by having the person with the lower tax rate pay tax" on the traditional IRA, says
Say the mother has
Also assume that the mother has a 40% combined federal and state tax rate, while the son's rate is 15%. She takes the
If instead the mother taps her traditional IRA for expenses, she must withdraw the entire
The son fares much better with the first strategy--getting the bulk of his inheritance from the traditional IRA. That's because the funds in the traditional IRA are "being taxed at the son's 15% tax rate instead of the mom's 40% tax rate," Reichenstein says.
What happens if the tax rates are reversed, with the son at 40% and the Mom at 15%? The son will inherit
When There's More Than One Heir
The calculations can be even more complex if a parent has two or more children with different tax rates. Giving each child an equal share of each account will lead to unequal after-tax inheritances, the study found. To equalize the inheritances, the parent should give the kid with the lowest tax rate a bigger share of the traditional IRA and the kid with the higher rate a larger share of the Roth.
Say a widower has a
Dad leaves half of each account to each child. Each child gets
To even out the legacies, Dad gives his son
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Susan B. Garland is Editor of Kiplinger's Retirement Report magazine.