Turning A Roth IRA Into An Estate Planning Tool

Throughout our Roth IRA series, we have explained in detail how you can use Roth IRAs during your lifetime to secure your retirement and manage taxes. There is one more area where Roth IRAs can help: estate planning. Using your Roth IRA as an estate planning tool is easy. You simply name a beneficiary or beneficiaries for all of your Roth IRA accounts. Although this is a minor administrative task in terms of time required, it is an important one that can have a significant impact on how these assets are managed and distributed after you are gone.

Naming Your Beneficiaries

Naming beneficiaries for your Roth IRA accounts only takes a few minutes of your time, but it can save a lot more than time for your heirs. In some cases, you may be required to name beneficiaries when you open your Roth IRA account. That is why it is important to give some thought to whom you would like to leave these assets with ahead of time, and how your chosen beneficiaries will be able to manage those inherited assets when the time comes.

Proper beneficiary designations for your Roth IRA can also keep those assets out of probate. Probate is the legal process of settling your estate supervised by the court, which includes dealing with any disputes about who inherits what. Probate can be an expensive and time consuming process that is open to public scrutiny.

Your Spouse

Spouses who inherit Roth IRAs have the most flexibility because they can treat it as their own Roth IRA account, which is known as a spousal transfer. This allows your spouse to continue to defer any required distributions for their lifetime, if they choose. Your spouse must be the sole beneficiary on the original Roth IRA, but they can then designate their own beneficiaries afterwards. This option helps to extend the tax-advantaged growth.

Alternatively, your spouse can choose to keep these funds in an Inherited IRA and take distributions over their lifetime. This is called a Stretch IRA strategy. This will eventually deplete the Roth IRA because they cannot add funds to the account and are required to take RMDs. The other beneficiary options available to a spouse are those that are also available to a non-spouse beneficiary (discussed below) and may or may not be as advantageous.

A Non-Spouse Beneficiary

When someone other than your spouse inherits your Roth IRA, they must take distributions either over ten years or as a lump sum. The ten-year timeline requires these non-spouse beneficiaries to distribute all the assets in the account within ten years of your death. Although there are no set RMDs in any given year, the full account balance must be paid out by the end of the ten-year period. Your beneficiaries also have the option to take their distributions all at once as a lump sum. If the account was in existence for at least five years prior to your death, all of these distributions will be free of federal income tax for your heirs.

Exempt Heirs

Some exempt heirs, known as eligible designated beneficiaries, are exempt from normal payout rules and can stretch inherited Roth IRA distributions over their own life expectancy. These beneficiaries include:

1. The surviving spouse of the original owner of the account.
2. Any person who is not more than 10 years younger than you.
3. Someone who is disabled or chronically ill. However, you may need to ensure the inherited Roth IRA funds are compatible with any governmental disability assistance benefits.
4. Minor biological or adopted children or stepchildren (but no grandchildren). These beneficiaries must take required distributions based on their life expectancy until they reach the age of majority when the ten-year distribution rule kicks in.

Naming An Entity As Beneficiary

You can name an entity as your Roth IRA beneficiary, which allows you to maintain more control over how the assets will be spent.

Although you can also name your estate as your beneficiary, this is usually not advisable. If your estate is your beneficiary, the money in the Roth IRA first flows to your estate, and then what's left passes to your heirs in accordance with the terms of your will or through the laws of intestacy if you don’t have a will. Generally, a five-year timeline will apply for distribution timing, which may not be optimal from a tax planning perspective and will subject the Roth IRA to the probate process as explained earlier. It can also unnecessarily expose your Roth IRA assets to creditors.

Naming a Trust as a Roth IRA beneficiary allows your heirs to benefit from your Roth IRA but only in accordance with the distribution terms of your Trust document.

If your Trust meets certain requirements, the beneficiaries of the trust can be treated as designated beneficiaries of the Roth IRA, not the Trust entity itself. When a qualifying trust is the beneficiary of a Roth IRA, post-death distributions are calculated based on the life expectancy of the oldest trust beneficiary.

This can reduce the time that distributions can be spread out, especially for the youngest beneficiaries. However, you may be able to establish separate trusts to enable each beneficiary to use his or her life expectancy when calculating required post-death distributions. It is a good idea to consult an estate planning attorney when considering this option.

Name A Charity As Your Beneficiary

This can be an attractive option if you don’t need or want to leave your Roth IRA to specific individuals. However, this renders the income-tax-free nature of the Roth IRA distributions irrelevant because a qualified charity is a tax-exempt entity. Your tax advisor can tell you if there is a more tax-efficient way to make this type of bequest.

Taking action

The income-tax-free nature of a Roth IRA can yield important benefits to your heirs. However, if your heirs are to realize the full extent of those tax benefits, it is important to consider carefully how you want your assets to be distributed upon your death.

Overall, it’s important to consider how your assets will be passed on after your lifetime. There are other factors that can be discussed in greater detail with your financial advisor. Beneficiary designations should be reviewed and adjusted on an ongoing basis as your circumstances change. Contact a Blue Chip Partners financial advisor today to learn more about your estate planning options.

Read more about Roth IRAs here.

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