Mistakes to Avoid When Passing a Roth IRA to Heirs

March 03, 2017
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The advantages of tax-free growth, has made the Roth IRAs an increasingly popular investment vehicle to leave to children or other loved ones.  But heirs won’t reap the full benefit of a Roth IRA if it isn’t passed down correctly. 

Roth IRAs are different from traditional IRAs in that contributions are made after taxes instead of before.  Withdrawals from a Roth in existence for five years or more after age 59 ½ are income-tax-free, as long as they are considered qualified and beneficiaries of an inherited Roth also don’t have to pay income taxes on withdrawals and additional growth in the account. 

Roth IRAs can be a very beneficial legacy for someone in the next generation. 

As Roth IRAs continue to gain in popularity and more people are set to inherit them many experts say it’s critical to avoid common mistakes that can knock the wind out of a Roth’s benefits. 

Common Roth Mistakes 

Here are four common mistakes made when planning to pass along a Roth---and how to avoid them. 

  1. Not naming a beneficiary. It might seem obvious, but when planning to leave a Roth IRA to heirs, it is critical that the account holder actually name the beneficiaries. 

That means account holders generally have to fill forms in addition to their will, spelling out who---or what trust---is going to get the Roth when the account holder dies. 

It is necessary to preserve the title.  Otherwise, your heirs may not be permitted to stretch out required distributions across their life expectancy, which is what gives the remaining assets more time to grow tax-free. 

By far the biggest benefits of the Roth IRA after death are tax-free growth in the account and the fact that distributions can be made without income-tax consequences. 

  1. Choosing the wrong beneficiary. While it’s common for Roth owners to choose their spouse as a beneficiary, careful thought should be given as to any additional beneficiaries.  Once the spouse dies for instance, the Roth can be passed along one more time to another beneficiary or group of beneficiaries. 

Choosing a grandchild or great-grandchild, to be the additional beneficiary can maximize the amount of time Roth assets have to grow income-tax-free. 

Here’s why: Roth beneficiaries who aren’t spouses generally must begin taking annual Required Minimum Distributions (RMD) by December 31st of the year following the year in which the account holder dies.  However, they can use a formula set by the IRS to stretch these withdrawals over their life expectancy.  The younger a beneficiary is, the longer his or her life expectancy is and the smaller the Required Minimum Distribution (RMD) is going to be.  For a young beneficiary, you can potentially stretch that income-tax-free for as much as 60 or 70 years. 

But keep in mind if the deceased account holder has a large estate, leaving a Roth IRA to a grandchild or great-grandchild, it could trigger estate and generation-skipping transfer taxes. 

  1. Forgetting to take required minimum distributions. Unlike with traditional IRAs, owners of Roth IRAs don’t have to take required minimum distributions. Or RMDs, while they are living. 

When spouses inherit Roths, they can roll the account into their own names and continue to defer RMDs.  But a non-spouse heir or anyone who inherits the Roth from the spouse generally has to start taking annual distributions (RMD).  Heirs must be proactive about this.  Failing to take distributions as required by the IRS can result in the money having to be withdrawn in five years, depriving the beneficiary of a lifetime of tax-free growth.  (Institutions and Brokerages don’t always remind you of them, so it’s up to the heir to stay on top of RMDs.)

  1. Making mistakes with a trust. In some cases, especially if the beneficiaries are young, it might make sense to use a trust to pass along a Roth IRA to the next generation.  But care must be taken to avoid a minefield of mistakes.  To qualify under IRS rules a trust that is a beneficiary of an IRA must have three characteristics: (1) It must be a conduit trust, (2) The trust must be domiciled in the residence state of the decedent and (3) A copy of the trust must be provided to the custodial institution within nine months of the account holders death. 

A conduit trust is one that names specific beneficiaries of the IRA account.  The trust then must make the Required Minimum Distributions (RMD) every year.  If this is not done right, the IRS can cause the entire Roth IRA to be distributed within five years. 

Conclusion 

To avoid the mistakes mentioned above, care and planning is a key factor to achieve the legacy benefits of a Roth IRA. We thank you for the opportunity to serve you with financial planning services and we thank you for your trust and loyalty.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

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