How to Use a Roth IRA to Avoid Paying Estate Taxes

Smart estate planning will minimize the tax bill that your heirs pay when you die, and a Roth individual retirement account (Roth IRA) is one of the most effective tools 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.
  

You Can Leave the Whole Roth IRA 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. Because 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 contract is sufficient to transfer outside of probate. In fact, the named beneficiaries on your Roth take precedence over anything stipulated by your will.

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.

Alternatively, the spouse can transfer the assets into an inherited Roth IRA in their name and opt to spread distributions over either their life expectancy or 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, adult children and other heirs cannot treat the IRA as their own.

Instead, 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 single year, but the full account balance must be paid out by the end of the 10 years. If the account existed at least five years prior to the account owner’s death, the distributed money will be tax free.

Some non-spousal heirs are exempt: those whose age is within a decade of the deceased’s, disabled or chronically ill individuals, or minor children. However, these minors must be the direct biological children, stepchildren, or adopted children of the account owner only (no grandchildren, in other words), and—when they reach majority age—the 10-year rule kicks in for them, too.

Roth IRAs Help You Avoid Probate

Like proceeds from a traditional retirement account or a life insurance policy, the money that you leave your heirs in 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.

The Bottom Line

It’s essential to designate a Roth IRA beneficiary to ensure that your wishes are carried out after you die. It’s equally important to periodically review your beneficiary designations (for all of your accounts) to make sure that 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.