If you have anything left in your traditional IRA when you die, it passes to the beneficiaries you name in your account paperwork. They can withdraw the money completely within five years or convert your account to a "stretch IRA" and keep earning interest for years. Another estate-planning option is to convert your traditional account to a Roth IRA before you die.
To create a stretch IRA, your beneficiary transfers your IRA assets to a beneficiary account. She must name it along the lines of "Sarah Smith beneficiary of John Jackson" or the IRS will treat it as a taxable withdrawal. Within a year she must start taking minimum annual withdrawals based on IRS life-expectancy tables. If she has 50 years to live and a $200,000 account, she takes out $4,000, for example. The rules are different if the beneficiary is your spouse: she can keep putting money in your IRA -- treating it as if it were always her own -- instead of opening a stretch IRA.
If your beneficiary inherits a Roth IRA, many of the rules stay the same: he has to set up a stretch Roth beneficiary account and make minimum withdrawals. Unlike a stretch traditional IRA, withdrawals from a Roth are tax-free. A $200,000 Roth IRA actually gives him more income than a traditional IRA, as there are no taxes taken out of the money. Non-spouse beneficiaries can't convert a stretch IRA to a Roth. You have to do it yourself before you die or it can't happen.
If you want to leave as much as possible to your beneficiary, converting to a Roth goes a long way. With a traditional account, you have to make mandatory minimum withdrawals every year once you turn 70 1/2. With a Roth, you never have to touch it if you don't need the money. That lets you leave a larger pot of money to your heirs than if you stuck with a traditional IRA.
If you're concerned about your tax bills, letting your beneficiary make the stretch IRA conversion can work out better for you. Roth contributions are taxable, so if you convert a traditional IRA to a Roth, you pay tax on the transfer. Roll over $200,000 and you have that much extra income for the year. You can make multiple smaller conversions over the years, reducing the tax bite per year. Depending on your finances, it may work out better for you to leave a traditional IRA and let your heirs stretch it out.
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