Before you inherit an IRA.

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For those inheriting a traditional IRA in the near future, funding the conversion cost with a gift may be an optimal strategy.  For those who expect to inherit an IRA, it can make great financial sense to gift the account owner – typically a parent - with the money with which to convert it to a Roth IRA, especially if the parents are currently in a lower tax bracket than the marginal tax bracket that the heirs will be in at the time they will be taking mandatory withdrawals from an inherited IRA.   Further, after a parent has converted to a Roth, RMD’s will no longer be required, permitting a potentially much greater sum of money to be transferred to the heirs, who will not be paying taxes on the withdrawals.  This is an especially good strategy for those who will be in their peak earning years when they inherit, and who would otherwise be taxed at a marginal rate approaching or exceeding a combined 50% under the current tax code – a percentage that may increase in the near future. 

For example, if a 65-year old spouse has a $500,000 traditional IRA, and incurs a marginal 35% tax rate on the conversion, then gifting $175k to pay the taxes on the conversion results in a Roth that (assuming a 6% growth rate) will have doubled to $2.15M if one member of the surviving couple lives to age 90, assuming that the surviving spouse is either the original owner or the beneficiary –more on that below.  If the Roth is then left to a 50-year old heir, the inherited Roth IRA will, again assuming 6% annual market return and minimum mandatory withdrawals, grow to approx. $4.3M when the heir turns 70, at which time the heir(s) can continue to make  tax-free withdrawals to fund their own retirement.  Overall, this hypothetical inherited Roth IRA would have generated about $7M in tax-free income during the children’s lifetime – all made possible with a (hypothetical) conversion cost of $175k. 

This simplified calculation doesn’t account for the fact that the future income streams would have to be “discounted”, using a hypothetical discount rate, in order to provide a true apples-to-apples comparison.  Nonetheless, without the Roth conversion,  the parents would have had to take required minimum (and taxable) distributions from age 70 ½ onwards, ultimately depleting the great bulk of the IRA, and leaving the heirs with an inherited IRA that would have generated the after-tax equivalent of, in all likelihood, significantly less than $1M.