Most people have at least a general understanding of Roth IRAs, but may not really understand how they might affect estate planning. Let’s see if we can clear up some of the questions and the most common confusion we see.
First, what are Roth IRAs?
William “Bill” Roth was a Republican U.S. Senator from Delaware for 30 years — from 1971 to his retirement in 2001. For the last six of those years he was the Chair of the Senate Finance Committee. That committee, along with the House of Representatives’ Committee on Ways and Means, writes and revises virtually all U.S. federal tax laws.
In 1997, Senator Roth championed a new kind of Individual Retirement Account. Hence the Roth IRA, which was adopted in the Taxpayer Relief Act of 1997. The new tax law was signed by President Clinton in August of that year.
Roth IRAs were immediately popular, and have grown significantly since they were initially adopted. But that begs the question:
How are they different from other IRAs?
Traditional IRAs and their Roth counterparts are similar, but different in important ways. Here are some of the differences:
- Roth contributions are always taxed before going into the account. That is, there is no income tax deduction for your Roth contribution. Most (but not all) regular IRA contributions are made before taxes. In other words, you get to deduct your IRA contributions from your taxable income in the year of deposit.
- When you hit a certain age (going forward, age 72 for everyone) you have to begin taking money out of your regular IRA. This is the required minimum distribution (RMD) (or, sometimes, minimum required distribution — MRD). There is no required minimum distribution for your Roth account. As we discuss below, the same benefit is not available to your heirs. But for the moment, bask in the knowledge that you can leave your Roth IRA invested.
- When you do take money out of your regular IRA, you pay income taxes on the whole amount (except to the extent that it includes after-tax contributions). But you pay no income tax on withdrawals from your Roth IRA. Though you paid tax on the money before putting it in, you never pay tax on the growth inside the account.
What about the similarities?
Both regular and Roth IRAs grow tax-free. Both allow asset changes without incurring taxes at the time. Retirement accounts generally enjoy creditor protection, and both kinds of accounts qualify.
In estate planning, we particularly worry about inheritance rules. If the account indicates a beneficiary, that designation will override wills, trusts or other estate planning documents. And if either type of account is left to a surviving spouse, they get special treatment.
When an IRA (or Roth) account owner dies naming a spouse, the surviving spouse may simply take over the account as their own retirement account. They name their own beneficiaries, and can even add the inherited account to their existing retirement accounts. Their minimum distribution rules reset to their own age, which is often younger than the deceased spouse. And the payout requirements for other beneficiaries are the same for both kinds of accounts, as well.
The SECURE Act, adopted late in 2019, reset the distribution rules for both IRAs and Roth IRAs. And this causes a lot of confusion for Roth IRA owners.
Remember that one of the benefits of the Roth IRA is that it does not require annual minimum distributions. Unfortunately, that is only true for the original owner. Well, the original owner’s surviving spouse can take advantage of that rule, as well — if they choose to “roll over” the Roth IRA into their own account. Everyone else (including the surviving spouse, if they don’t roll over the account) has to immediately begin taking distributions from the Roth IRA.
Well, there are three categories of beneficiaries:
- The first group (and, happily, the least common) are beneficiaries who don’t meet the IRS definition of “designated beneficiary.” This might mean that the account named the owner’s estate as beneficiary, or named a charitable entity. The bad news: those beneficiaries have just five years to empty the account. The good news: very few people make this mistake (unless they are leaving their account to charity — and that actually can make good sense).
- The second group includes most other beneficiaries. Adult, competent children? They fit here. So do most other relatives. In fact, this is by far the largest group of beneficiaries (well, other than spouses, anyway). Members of this group have ten years to empty the inherited account.
- The last group includes five specific categories — or, in some cases, trusts for the benefit of someone in those categories. Their minimum distribution rules allow them to use their own life expectancies, though sometimes only for a limited period. In the case of Roth IRAs, that can mean particularly powerful benefits, since they don’t pay any tax on what does get withdrawn, and the balance continues to grow tax-free. Members of this group (called “eligible designated beneficiaries“) include:
- surviving spouses
- the account owner’s minor children (not just any minor children, but the owner’s own — grandchildren do not qualify)
- one or more disabled individuals (like, for example, the beneficiary of a special needs trust)
- one or more chronically ill individuals (this category is not as broad as it sounds)
- anyone else who is less than 10 years younger than the owner
What does all this mean for estate planning with Roth IRAs?
First, it is important to recognize that the two best-known benefits of Roth IRAs do not behave the same. Yes, withdrawals from your Roth after your death are still tax-free for your beneficiaries. But no, they don’t get to keep avoiding the withdrawals indefinitely. In fact, most beneficiaries have a pretty short (5-10 year) window in which to take out their funds.
That makes for some differences in the “value” of your Roth IRA to different kinds of beneficiaries. Charities? They make great IRA beneficiaries, but not as great Roth IRA beneficiaries (they’re not going to pay income taxes anyway, so you’re “wasting” the tax-free benefit of the Roth IRA). Your minor children? They make great Roth IRA beneficiaries, since they don’t have to take as much out of the account each year. Until they reach majority, that is — then they have ten more years to empty the account.
How about special needs beneficiaries? They can be great Roth IRA beneficiaries, since they can leave the money in the account for many more years. But probably the account has to name a special needs trust for that beneficiary. And the tax benefit may be wasted, depending on whether the beneficiary — or their trust — would be paying any taxes anyway. This one can be a great choice, but it really requires you to talk through the calculations with your estate planning attorney AND your CPA.
Adult children can be great Roth IRA beneficiaries. They usually have to take out the money in ten years, but it’s tax-free when they do take it out. Are your children professionals, with high incomes? They’ll thank you for leaving the Roth IRA to them, and the other retirement accounts to others.
Is there more to consider?
Oh, lordy, lordy, lordy. There’s lots more. We haven’t talked about Roth conversions, or dividing Roth IRAs (or other retirement accounts) in divorce, or the value of naming a spouse as primary beneficiary. We haven’t even mentioned that there is such a thing as a Roth 401(k), which became available in 2006 and has many of the same features (and benefits) as a Roth IRA. And we haven’t touched on how to make Roth contributions even when you seem to be precluded from doing so because your earnings are too high (these are sometimes called “back-door” Roths). But we’re worn out. And we need to get working on our taxes.