roth-ira

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Traditional IRA vs Roth IRA: Which is Better To Inherit?

While traditional and Roth IRAs are both valuable tools for retirement savings, they have some key differences. T&W clarifies these differences here.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

If you’re getting ready to save up for retirement, you’re probably wondering which type of retirement account you should use. Financial institutions offer a myriad of retirement savings plans, all of them with their unique advantages and disadvantages. While having a lot of options to choose from is great, it can also be difficult to navigate. Today we’ll tackle the debate between two of the most popular options: the traditional IRA vs Roth IRA. This guide will clarify the key differences between these two types of retirement accounts, and discuss which might be the better choice in the context of inheritance planning

What is the Difference Between Roth and Traditional IRA?

The Roth and the traditional IRAs are two different types of individual retirement accounts (IRAs). These are accounts that you can use to save up for your retirement. According to SmartAsset, the average return on IRA accounts is between 7% and 10%. This means that any money you can contribute to your IRA will grow over time; the earlier you can start saving, the better. 

Both the traditional and Roth IRA offer different tax benefits, thus giving you a different set of advantages. Almost any financial institution will offer either type of product, leaving it up to you to choose your personal preference. 

Your decision can be made by comparing the advantages and disadvantages in 4 main categories: taxes, contributions, withdrawals, and estate planning. We discuss these differences in the sections below:

Taxes

Roth: A Roth IRA is unique from the traditional IRA because it lets you make after-tax contributions. This means that your contributions get to grow in a tax-free environment, and that you won’t get taxed when you eventually make withdrawals. However, this also means that you don’t get to receive any tax benefits in the years that you make contributions.

Traditional: Many retirement savers opt for the traditional IRA because it grants them immediate tax benefits. You get to deduct your contributions from your income, which thus gives you a tax break. However, note that this means that your savings grow in a tax-deferred environment. In other words, withdrawals you make in the future will be taxed as income and will lower the amount of money you get to put in your pocket.  

Contributions

Roth: As discussed earlier, Roth contributions are made from after-tax dollars. According to Forbes, the 2022 contribution limit is $6,000 for those aged 49 and younger, and $7,000 for those aged 50 and older. Note that there are some restrictions on who can contribute to a Roth IRA. The limit stands at the Modified Adjusted Gross Income (MAGI) of $129,000, up from $125,000 in 2022.

Traditional: Contributions to a traditional IRA account can be made with either pre-tax or after-tax dollars. In 2022, the maximum contribution is $6,000. If you are over the age of 50, then you can contribute up to $7,000. Anyone with earned income is eligible to contribute to a traditional IRA. 

Withdrawals 

Roth: The reason why Roth IRAs are so advantageous is that you contribute after-tax dollars to your account. You’ve already paid your income tax, meaning that you won’t have to pay a second time when you make withdrawals. Second, you’re not forced to make any withdrawals if you don’t want to. Your savings can continue to grow in a tax-advantaged environment if you should so choose. Any withdrawals you make will be penalty- and tax-free after you’ve had the account for 5 years and are aged 59 ½ and older.

Traditional: Traditional IRAs have a few more restrictions pertaining to withdrawals, relative to the Roth IRA. For starters, any withdrawals you make after the age of 59 ½ are taxed as income. They also require mandatory distributions once you reach the age of 72. 

Estate Planning

Roth: Many financial advisors cite Roth IRAs as a great tool to pass on as an inheritance for your children. This is because you’ve already paid your taxes on it, so your children get to inherit any remaining sum and make withdrawals tax-free. However, be sure to consider your tax rate versus your children’s potential tax rate. Any taxes you pay today will impact how much money you’re able to contribute to the account, which could be an opportunity cost in itself. However, if your children will have equal or higher tax rates relevant to yours, then it could be beneficial to bequeath them a Roth. If you have a traditional IRA, then don’t worry, you can convert it to a Roth IRA.

Traditional: If you have a high tax rate, then consider bequeathing a traditional IRA over a Roth IRA. This is because if you have a high income and high net worth, your contributions may be better off growing in a tax-deferred environment. If your children have lower net worth, and thus lower tax brackets, it could be advantageous for them to inherit a large pre-tax account. They can then liquidate it at their own personal tax rate at the time.

Traditional IRA vs Roth: Which is Better To Inherit? 

The fascinating thing about retirement planning is that the choices we make can change once we take into account our estate planning and inheritances.

As an adult saving up for retirement that feels far away, we tend to choose the option that benefits us personally. However, that choice doesn’t necessarily always benefit your future generations. Earlier, we discussed the difference between a Traditional IRA vs Roth, and how you might want to choose one over the other in the context of estate planning. 

The decision tends to come down to taxes, and who would benefit more from any tax advantages. 

In most instances, it’s most beneficial for your children to inherit a Roth IRA. This is because you already paid the taxes on your contributions, meaning that they don’t have to worry about paying any income tax when they inherit and liquidate your account. You won’t have to play a guessing game of what their tax bracket might be, and whether or not it’s beneficial to save up pre-tax or after-tax dollars.

The one instance you might want to bequeath a traditional IRA instead is if you have a substantially higher tax bracket than your heirs. Let’s say you are a high net worth individual, and you’re contributing a lot of pre-tax dollars to your IRA. If your child is in their 20s and is struggling to get by, they will benefit from inheriting a large account and paying their personal, lower tax rate. From the perspective of multigenerational wealth, you could possibly lose less money. 

Understandably, it’s difficult to predict the future, especially if we are on the younger side ourselves. We may not even have children yet, or we may have no idea what our children’s tax brackets will look like one day. 

If you decide to take the tax advantage today and choose the traditional IRA, don’t worry. You always have the backup option to convert your IRA to a Roth IRA in the future. You will be required to pay income tax on any untaxed amount you’ve converted, but you’ll also be removing income taxes from your estate. You would essentially be creating a gift for your heirs with no gift tax consequences.

Update Your Estate Plan to Include Your IRA Today

It’s difficult to settle the traditional IRA vs Roth IRA debate once and for all because they are both great options that can benefit most individuals in some way, shape, or form. In this guide, we talked about how traditional IRAs and Roth IRAs both present their unique sets of advantages and disadvantages in 4 categories: taxes, contributions, withdrawals, and estate planning. However, there is a preference toward the Roth IRA in the context of estate planning. This is because you’re contributing after-tax dollars. You’re not forced to make any minimum withdrawals, meaning your nest egg can continue growing for your loved ones. Further, they won’t have to pay any taxes when they liquidate the account. However, make sure to measure the opportunity cost of contributing pre-tax dollars, especially if your child might have a much lower tax bracket than yours. 

Feeling stressed about choosing between the two options? This is a great time to pause, take a step back, and consider the bigger picture. Regardless of which option you go with, you’re setting yourself and your family up for success. The simple yet challenging act of saving for retirement and further, planning your estate, is a phenomenal accomplishment of its own. Know that these options are at your disposal, and you can always make changes if you realize one option was better than the other. 

Should you need to change and update your Estate Plan to include your new IRA and beneficiary designations, we’ve got your back. Trust & Will makes it easy to keep track of your assets, update your documents, and make sure the proper protections are in place. Get started today.

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