Smart estate planning will help minimize the tax bill when you die, and a Roth IRA is one of the most effective tools you can use for that purpose. Aside from all the other good things about Roth IRAs, there are two additional reasons you might want to include one in your estate planning.
- You don't have to take distributions from a Roth IRA during your lifetime, so if you don't need the money you can leave it all to your heirs.
- Your heirs will be able to make tax-free withdrawals over a five-year period from the Roth IRA.
- Spouses who inherit Roth IRAs have even greater flexibility.
You Can Leave the Whole Account to Your Heirs
One of the major advantages of a Roth IRA, unlike traditional IRAs and many types of retirement plans, is that you don't have to take any required minimum distributions (RMDs) during your lifetime. So 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 rules for what happens when you leave your Roth IRA to someone depend on whether the beneficiary is your spouse or another person (or persons). Spouses, for example, have the option of designating themselves as the account holder and treating the Roth IRA as if it were their own.
Other kinds of beneficiaries cannot do that but must typically withdraw all the money from the Roth account within a five-year period after you die. As long as you had a Roth account for at least five years, those distributions are totally tax-free. But even if you didn't, only the account's earnings, not the contributions you made to the account, are taxable. Your original contributions were made with after-tax dollars, so they've already been taxed.
You can read more about inherited Roth IRAs and how they're taxed in IRS Publication 590-B.
Be sure to keep your Roth IRA's beneficiary designations up to date, so the money will go where you want it to go.
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 disbursing of funds to your loved ones and can reduce the cost of settling your estate.
The 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 possibly 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.