A question came up at tonight’s landlord meting:

Keeping the numbers simple, is your kid better off inheriting your $1 million Roth IRA or your $1 million real estate portfolio?

At the time of your death, the after tax value of the Roth IRA is $1 million for your kid.

At the time of your death, the after tax value of the real estate portfolio is $1 million for your kid (less sales commission).

If the kid inherits a $1 million Roth IRA, the kid can leave the money in the Roth IRA and it will grow tax free for 10 years. The Roth IRA account has to be withdrawn completely 10 years after your death. Tax free growth for 10 years.

If the kid inherits $1 million in real estate, that could be 5 houses at $200k per house. These houses are currently renting for $1350/month in this area.

So, which is better? Inherit the IRA or houses?

I want to say real estate is the best asset to inherit, but, my analysis shows the Roth IRA is worth more at the 10 year period, and if reinvested in a taxable asset, it will be worth more than the 5 houses when the kid dies.

Any comments?

MMIT,

I say leave him the Roth. He can use it to buy RE IF he is interested - in HIS town, with HIS preferences, with HIS timing, etc

Rentals are work and are only profitable when managed properly.

A common question posed here what to do since my kids are not interested in rentals.

BRAD

Too many variables to accurately calculate the two numbers. IE: what return in stocks on the IRA over the 10 years and then after divestiture from the IRA? What will the capital gains tax rate be in 10 years for the IRA and 50+ years for the RE? How much will rents go up over the years? maintenance costs? Property Appreciation?, and on and on.

I can make some educated observations though. Assuming rent on a $200,000 house is $1350 as you stated. Also, assuming that about 30% of the gross rent will be spent in operating expenses (vacancies, taxes, insurance, repairs, etc). Then the property is only yielding a 5.67% return and that's with you doing the management. While returns vary widely in the stock market, historically the S&P 500 has yielded 11.3% over the last 50 years. You will pay some management and brokerage fees so let's just say 10%. You might add another 2.5% or so on average in property appreciation so a 8.17% return on the RE side. Of course, those don't take in the tax considerations, RE will fare better (at least today) on that front but it's a big guess if it will overcome the spread between 8.17% and 10%.

For most people it becomes a question of how many years do you have to recoup the initial tax hit of doing the "converting" a traditional landlord retirement plan into a Roth.

There simply isn't a clear answer here as there are some many assumptions that have to be made. Here is a calculator that compares traditional vs Roth so you can fill in the blanks

There's also the possibility of the govt changing the rules and the taxes they take from you on either scenario.

And also that either of these choices could run into negative setbacks like the price drop in 2008-2012 in real estate or stock market reversals of perhaps 50 percent.

If any of this happened at the time the kid needed or was required to take the cash out of the IRA or sell the real estate it would change all the numbers.

On the positive side, be happy, even extatic that you can leave that much to the kid, whichever way you do it.

I prefer to spend my money, die broke and happy.

My kids should already be on their way to making their own happiness.

I think if your kids inherit the rentals they get them on the stepped up basis.

From a passive perspective, the Roth wins.

From an active perspective, the Real Estate wins.

What are your heirs best equipped to handle emotionally and skill-wise? I would suggest the old test: have them take out five $100 bills, wad them up, and flush them down the toilet, then call a plumber and pay to unclog it. If they can do that, they might be cut out for real estate investing.

Unless there is something unique about the real estate that makes in irreplaceable, the Roth would win in every reasonably possible scenario here. If the heir wants to own real estate, they should be able to buy at least $1.25M worth of property with the $1M cash if they know what they are doing. So instead of 5 $200K houses, they should wind up with 6.

Whenever I've run the numbers between just investing it (like in an S&P 500 fund) or buying a property outright, the numbers pretty much ALWAYS favor investing it instead. But, that isn't how or why I buy real estate. I bought real estate when I could only afford the down payment -- and then let me renters pay for that mortgage over 20 years.

So, in other words, if I had the option of $1,000,000 handed to me in that Roth IRA -- or 5 $200,000 paid-off houses -- then I'd take the Roth IRA.

But, when I ACTUALLY did when I started in real estate would mean that I would take the money and use it only as a down payment. So, maybe $50,000 each for 20 houses. Then rent them and let the tenants pay for those mortgages. Then, 10-20 years from now, I've got 20 houses. THAT might be better than 10-20 years in the S&P 500.

So, by setting this question up to be the same amount in a Roth IRA or a small number of paid-off homes, it makes it easier for the numbers to show that not doing real estate likely makes the most sense.

But if you change it a bit to actually INVEST in real estate like I have over the past 20+ years (i.e. using money for down payments only), then that can change the outlook quite a bit.

If they inherit the IRA how long will it take them to spend it?

The average appreciation stock market rate over the years can be misleading. Because the average rate is meaningless if one of the years included in the average calculations depreciated.

The compound rate of appreciation is more accurate than the average appreciation rate.

Let’s say that I invest $10,000 into the stock market. After 1 year, it rose 50 percent. The next year it dropped 50 percent. The average rate is 0 percent. Adding +50 and -50 equals zero.

What is the reality? $10,000 with a 50 percent increase is $15,000. $15,000 with a 50 percent decrease is $7,500. While the average rate is 0 percent, I lost $2,500 over the 2 years. Average rates are ok, if you don’t have a year with a negative rate.

The compound rate doesn’t have that weakness.

If I look on Zillow for a property that sold for $120,000 fifteen years ago and now it is worth $250,000. I can use the HP 12C calculator to find the compound rate. The annual compound rate is 5.01 percent.

It gives me a likely appreciation rate to predict that the $250,000 property will be worth $520,000 in another 15 years. My family can’t grasp that it will appreciate that much in dollars, but it did grow at that compound rate over the last 15 years.

Usually I hear stock brokers quote the average appreciation rate for stocks over the years, not the compound rate.

I just watched a video about retirement/downsizing with the theme "Your kids don't want your furniture".

We boomers save stuff we feel is valuable for our kids.

We saved all kinds of stuff when my parents passed, like the family dining table, the expensive leather chair, the plates we ate from every day...

Nobody will take ANY of it.

Same with houses.

...unless they are LAKE houses!

BRAD

Brad, you are correct - the kids don’t want any of the household “stuff”. Even though it has been in the family for generations. They prefer IKEA furniture.

They don’t even care about Grandma’s silver silverware.

They are not interested in my shacks or the family house they grew up in.

They want the money.

I need to go back through the storage room in my house and start weeding stuff out. I still have a room full of my youngest kids stuff. He doesn't want it but won't take it or get rid of it either.

Heartland, the numbers I quoted for the S&P are accurate. The statistic takes the cumulative (or compound) appreciation for the period and divides by the number of years in the period to come up with the average. The basis of the investment is established at year one and again at the conclusion of the 50 years so any negative years in the middle are immaterial. Below is a calculator that will show you not only the beginning and ending value, but how that value was achieved (price change, dividends, etc) over a series of years of your choosing.

More thoughts...

NOW is a good time to talk to adult children about THEIR wishes. One of my siblings wanted to inherit one house to "try RE". Reasonable.

MikeA: Agreed. That is exactly what I was saying above. That sitting on the money in an IRA is much easier than sitting on that much property paid-off -- and likely not worth the hassle of landlording. But if you change it to INVESTING that money in down payments of MORE real estate, then that is a very, very different picture.