4 Mistakes Clients Make With Roth IRAs and Their Estate

Roth IRAs are popular accounts for investors to leave to their heirs because of their tax-free status. Contributions are made with after-tax money and distributions are tax-free as long as the account owner is at least 59.5 years old and has had a Roth IRA or retirement account open for at least five years.

The beneficiaries can also continue to enjoy this tax-free status when they inherit the account. However, they will not be able to maximize their tax savings with the Roth unless it is passed down in a certain manner. Advisors need to know how to make the most of a Roth inheritance to ensure that their clients come out the furthest ahead. (For more, see: Top 10 Mistakes to Avoid on Your Roth IRA.)

A Tax-Free Legacy

Roth IRAs can provide beneficiaries with a lasting tax-free gift. Scott Sparks, a wealth management advisor with Northwestern Mutual in Denver, told The Wall Street Journal that “from a legacy giving standpoint, it’s one of the more beneficial gifts that a person can pass on to the next generation.” Roth IRAs now hold nearly $660 billion in cumulative assets, and they are one of the most popular ways for investors to save for retirement.

But there are several distinct mistakes that many people make when it comes to passing these accounts down to the next generation. The list of these common errors includes:

  • Failure to name a beneficiary. This is perhaps the most obvious error that a Roth IRA owner can make. If no beneficiary is listed, then the account transfer may be determined by the deceased’s will, but this can be complicated. Roth IRA owners should name their beneficiaries as soon as they open the account, and change them according to their wishes at the earliest possible time. This will ensure that the money in the account goes to the person for whom it was intended. Most Roth IRAs have separate beneficiary forms that need to be completed in order to do this.
  • Choosing the wrong beneficiary. Married couples usually list each other as the primary beneficiaries for their Roth accounts. When one spouse dies, the other spouse usually inherits the money and then it is passed on again to another beneficiary upon the death of the second spouse. But it may be wise to leave the money to a younger beneficiary, because they can stretch the distributions out over their lifetimes and enjoy tax-free distributions that may last for decades. Bobbi Bierhals, a partner at law firm McDermott Will & Emery in Chicago, told the Journal that “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. You can potentially stretch that income tax-free growth for 50, 60 or even 70 years.” However, leaving a Roth to a younger beneficiary may trigger estate or generation-skipping transfer taxes in some cases. (For related reading, see: What Are the Risks Associated With a Roth IRA.)
  • Neglecting to receive required minimum distributionsNon-spouse beneficiaries who inherit a Roth IRA are usually required to begin taking distributions from them by December 31 of the year after the year in which the previous account owner died. If the beneficiary fails to do this, they may be forced to withdraw all the money within five years instead of spreading the distributions out over their lifetime.
  • Using a trust incorrectly. Pouring Roth assets into a trust after death can be a good idea—as long as it’s the right type of trust and the designated beneficiaries are specifically named in the trust. The trust needs to be a conduit trust that will take out the RMDs each year. The trust needs to spell out all of the details pertaining to the distributions and beneficiaries or else the IRS may require that the trust disperses all of the income in the account within five years.

The Bottom Line

Roth IRAs can provide beneficiaries with tax-free income for life if they are handled properly. Account owners need to make certain that the correct beneficiaries are listed on their account. Those who are naming a trust as the beneficiary should seek out legal and financial counsel in order to make sure that the money will be distributed correctly. For more information on Roth IRAs, you can download Publication 590 from the IRS website at www.irs.gov.(For related reading, see: An Introduction to Roth IRAs.)