It is easy to understand why most people think it is always better to inherit a Roth IRA than a traditional IRA. Distributions from the Roth IRA are tax-free and they are not from a traditional IRA.
Not having to pay taxes always seems better than having to pay them.
As the USA Today pointed out in a recent article entitled "Inheriting a Roth IRA isn't always best news," when it comes to IRAs things are not as simple as they seem.
What is often ignored is that taxes have to be paid when an IRA is converted from a traditional one to a Roth IRA.
Consequently, Roth IRAs do not magically shield the money from taxes. The money is just taxed at a different time.
While it still might seem better strictly from the perspective of the person inheriting the IRA (if he or she is not the one who must pay the taxes upon conversion), that is not necessarily true if the IRA is smaller as a result of converting it.
The general rule of thumb is that if the person who will inherit the IRA has a higher tax rate than the person who currently holds it, then a Roth IRA is better. Conversely, if the inheritor has a lower tax rate, then it is generally better to keep it as a traditional IRA.
What if the tax rates for the current owner and the original inheritor are the same?
Then a Roth IRA is better. Unfortunately, it still is not that simple.
Be sure to consult an estate planning attorney, so you can decide which type of IRA is best for all concerned … except, of course, when it comes to the IRS.
Reference: USA Today (Jan. 20, 2016) "Inheriting a Roth IRA isn't always best news"