#3 – There are no RMDs for life insurance
When you leave a Roth IRA to non-spouse beneficiaries, such as children, the beneficiaries must generally begin taking RMDs (required minimum distributions) from the inherited Roth IRA no later than the year after they inherit. These distributions are usually tax-free, but they must be taken nonetheless.
When beneficiaries inherit life insurance, there are no RMDs to worry about. Here’s something to consider, however. While not having to deal with RMDs is nice, that fact doesn’t necessarily make life insurance a better — or more tax-efficient — option for legacy planning than a Roth IRA.
Here is the reason: When a beneficiary inherits life insurance, the only amount they’ll receive tax-free is the actual life insurance proceeds. If they don’t need the money right away, they might invest the proceeds, but whatever interest, dividends, capital gains or other income those investments generate will be taxable (unless they are invested in assets that don’t produce taxable income, such as municipal bonds).
In contrast, while the inherited Roth IRA will have RMDs to deal with, those amounts may be relatively minimal and the future growth in the Roth IRA remains income tax-free.
Take someone who inherits a Roth IRA at age 50, for example. In this case, RMDs would start out at roughly 3 percent of the account value. The rest of the Roth IRA, however, can be left alone to grow, and that growth can later be distributed tax-free as well.
So, whereas a beneficiary of a $500,000 life insurance policy will “only” receive $500,000 income tax-free, a beneficiary inheriting a $500,000 Roth IRA may receive many times that amount in tax-free distributions over the course of their lifetime, particularly if they stick to taking only the RMD each year and no more.
The Bottom Line
If you are looking to leave a legacy to your heirs when you die, there are many tools to consider. Life insurance and Roth IRAs are but two of the many options.
In some cases, life insurance may not be available due to poor health. In other cases, such as when your beneficiaries will be in a lower bracket than they are now, there may be a greater net benefit by leaving them larger amounts of tax-deferred accounts, like IRAs instead of a smaller amount of Roth IRAs.
The bottom line: Every situation is different and there’s no one-size-fits-all solution. Surely though, Roth IRAs and life insurance offer two potentially very efficient options.