Converting sooner than later, could yield a bigger account to your heirs; do the math first
Deciding whether or not to convert a traditional IRA to a Roth requires crunching the numbers. If your plan is to leave the IRA to an heir, you’ll want to work with an estate planning attorney to make sure that the decision has a positive outcome. The Roth IRA grows tax-free during your lifetime as well as the lifetime of your heir. The Vanguard Group conducted a study that demonstrated how converting a traditional IRA to a Roth can create a larger legacy but it’s not applicable to every situation.
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.
By using outside funds to pay the tax bill, there’s more money in the tax shelter, giving its growth a serious boost and making it even a bigger bargain. Since Roth RMDs are tax-free, your heir will be able to invest 100% of the withdrawals, so the money can continue to grow tax-free.
Reference: Kiplinger (March 2017) “Roth Conversions May Be Boon for Heirs”