(Investopedia) - Smart estate planning will minimize the tax bill your heirs pay when you die, and a Roth IRA is one of the most effective tools that can be used for that purpose. Aside from all the other positive characteristics of Roth IRAs, there are two reasons for including one in your estate planning.
- You are not required to take minimum annual distributions from your Roth account. If you don't need the money, the account can continue to grow in value until your heirs receive it.
- With a properly designated beneficiary, your Roth account will not be included as part of an estate in a probate process. The balance will go directly to your designated beneficiary.
KEY TAKEAWAYS
- You don't have to take annual distributions from a Roth IRA during your lifetime, so if you don't need the money you can leave it all to your heirs.
- Heirs, in most cases, can make tax-free withdrawals over a 10-year period from the Roth IRA.
- Spouses who inherit Roth IRAs can treat the accounts as their own. That is, there are no deadlines for withdrawals.
You Can Leave the Whole Account to Your Heirs
One of the major advantages of a Roth IRA, unlike traditional IRAs and many other types of retirement plans, is that you don't have to take any required minimum distributions (RMDs) during your lifetime. Since you already paid the income taxes due on that money, the Internal Revenue Service (IRS) doesn't care when you use it.
If you don’t need the money for living expenses, you can just leave it in the account to keep growing tax-free. This makes a Roth IRA an especially good vehicle for wealth transfer. The entire funds deposited into the account, plus earnings, can transfer to your beneficiaries. You don't even need to identify a beneficiary in your will because the beneficiary designated on your Roth IRA account contract is sufficient to transfer outside of probate.
How Your Heirs Can Avoid Taxes
Spouse Beneficiary
A spouse who inherits can choose to become the account holder of the Roth IRA without any changes; this is called a spousal transfer. That is, no taxes should be owed on withdrawals from the account and no minimum distributions are required. Or, the spouse can transfer the assets into an Inherited Roth IRA in their name, and opt to spread distributions over their life expectancy or over five years. In all cases, the money remains tax-free.
Non-Spouse Beneficiary
It used to be that non-spousal beneficiaries could stretch distributions over their own life expectancy as well. However, as of Jan. 1, 2020, adult children and other heirs cannot treat the IRA as their own. Most must withdraw all of the money in the Roth account within 10 calendar years of the date when it was inherited. There are no set RMDs in any one year, but the full account balance must be paid out by the end of the 10-year period.5 If the account was in existence for at least five years prior to the account owner's death, the distributed money will be tax-free.
Some non-spousal heirs are exempted: those whose age is within a decade of the deceased's, disabled or chronically ill individuals, or minor children.7 However, these minors must be the direct biological, step, or adopted children of the account owner only (no grandchildren, in other words), and—once they reach majority age—the 10-year rule kicks in for them, too.
Be sure to keep the beneficiary designations on your Roth IRA and other financial accounts up to date, so the money will go where you want it to go without delay.
Roth IRAs Help You Avoid Probate
Like proceeds from a traditional retirement account or a life insurance policy, the money you leave your heirs in the form of a Roth IRA doesn’t have to go through the probate process. This simplifies and speeds up the disbursement of funds to your loved ones and can reduce the cost of settling your estate.
Mutual fund companies, banks, brokerage firms, and other financial institutions that serve as custodians for Roth IRAs will typically require you to designate a beneficiary—and sometimes alternate beneficiaries—when you open your account. Don't name your estate as a beneficiary or you'll lose the opportunity to bypass probate.
It’s important to designate a beneficiary to ensure that your wishes are carried out after you die. It's equally important to review your beneficiary designations periodically to make sure they are up to date, especially after major life events, such as marriage, divorce, the birth of a child, or the death of a previous beneficiary. For example, your current spouse might not appreciate seeing your Roth IRA go to a former spouse because you forgot to update the form.
Do Roth IRAs Have Required Minimum Distributions (RMDs) During the Account Owner's Lifetime?
No. Unlike traditional IRAs, there are no RMDs for Roth IRAs during the account owner's lifetime.
If I Fail to Designate a Beneficiary—or My Beneficiary Precedes Me in Death—What Happens to My Roth IRA?
If you do not have a properly designated beneficiary at the time of your death, the proceeds from your Roth IRA will go through your estate and the probate process.
Do Beneficiaries Pay Taxes on Withdrawals From an Inherited Roth IRA?
Typically, no. A beneficiary does not have to pay taxes on withdrawals from an inherited Roth IRA so long as the account owner opened—and began making contributions to—the account more than 5 years prior to their death.
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By GREG DAUGHERTY
November 17, 2021
Reviewed by ERIC ESTEVEZ
