Dear Liz: Since retiring, I’ve been converting a traditional pre-tax IRA to a Roth IRA. I’ve got another small pre-tax account that I could do the same with. My reason for converting is that my spouse has a very large pre-tax IRA that probably won’t be used up in our lifetimes, and I don’t want my adult children to face a large tax bomb when we both are gone.
Is there any downside to including our kids as beneficiaries for that account, say 10% each? That way, if he dies before I do, some of the pre-tax account will be delivered to the kids (starting the 10-year distribution clock), and then they’d have another 10 years to withdraw (and pay taxes on) whatever remains at my death. I could foresee adding grandkids as beneficiaries as they approach adulthood.
Is this a bad idea? Would it be better to continue whittling down the pre-tax accounts by converting them to Roth accounts?
Answer: Last week’s column covered some of the hazards of leaving retirement accounts to minor children. If the account was owned by anyone other than a parent, distributions would need to start immediately and likely would be subject to the parent’s tax rate. Plus, handing a big wad of cash to a teenager or young adult often isn’t advisable. You can control the distributions by creating a trust, but that has its own tax implications.
Including your adult children as beneficiaries isn’t as fraught with peril, but you do lose some flexibility. The surviving spouse is allowed to treat an inherited IRA as their own, which may allow them to delay distributions. Plus if the kids are in their peak earning years when they inherit, they could wind up paying taxes at high rates.
Continuing with the Roth conversions may be a better way to defuse the tax bomb, particularly if your tax rate is lower than theirs and you’re willing to foot the tax bill. You’re reducing the size of the taxable IRA while creating a tax-free pot of money for your heirs. Obviously you’ll want to discuss all this with your tax pro and your estate planning attorney before proceeding.