The Roth Legacy Trust^(SM)

by Robert S. Keebler, CPA, MST and Michael Bleck¹
© 1998, Robert S. Keebler, Michael Bleck

(This article is available exclusively on the Roth IRA Web Site)

The Roth Legacy Trust^(SM) promises to be a exciting wealth transfer planning technique available to many IRA holders. In the past six months, much has been written about the advantages of the Roth IRA. Included in these advantages are the ability to defer distributions after 70½ and the ability to name a new beneficiary after age 70½. It is important to understand the advantages of the Roth IRA before discussing the stretch-out potential available in a Roth Legacy Trust^(SM).

REQUIRED BEGINNING DATE PLANNING²

At age 70½ one does not need to take distributions from his or her Roth IRA.³ Rather than taking funds from the Roth IRA and reinvesting them in an investment account, one can simply continue the deferral within the Roth IRA. The chart below shows the value of this deferral beyond the required beginning date. If the IRA is a traditional IRA, the owner must begin taking minimum distributions. This is illustrated in the three columns under the heading "Traditional IRA." The required minimum distribution is invested, after-tax (30% tax rate), in an outside account that earns 10%. It is also assumed that the outside account growth is taxed at 30%. In contrast, the Roth IRA is not subject to minimum distributions during the IRA owner’s lifetime. Therefore, the $500,000 beginning balance will continue to grow tax-free until the account owner’s death. This is shown in the three columns under the heading "Roth IRA."

NAMING A NEW DESIGNATED BENEFICIARY AFTER 70½

Under the law there is no required beginning date for the Roth IRA.⁴ Accordingly, after age 70½ one can name a new beneficiary which will be effective for both property law and income tax purposes. When working with traditional IRAs, one of the biggest stumbling blocks is the fact that if a client’s spouse dies after the client’s required beginning date, the client will not be allowed to name a new beneficiary for income tax purposes.⁵ Several examples are shown below:

Example: John, age 75, named his spouse Jane as the designated beneficiary of his $500,000 traditional IRA as of his required beginning date. Jane predeceases John. John is not allowed to name a new beneficiary for income tax purposes in order to calculate his required minimum distribution. He will be required to take his required minimum distribution based on the elections he made at his required beginning date, presumably over both his and his deceased spouse’s remaining fixed life expectancy.

Example: Same facts as previous example except the IRA is now a Roth IRA. After Jane’s death, John can name a new designated beneficiary for tax purposes. Therefore, he could then name his children, still with no required distribution during his lifetime. At John’s death his children will be able to take the Roth IRA out over their single life expectancy. This allows for substantially more deferral when compared to the previous example.

As the above table illustrates, being able to name a designated beneficiary after one’s required beginning date can create a longer deferral period. One of the key advantages of both ordinary IRAs and Roth IRAs is the ability to "stretch-out" an IRA over the life expectancy of the designated beneficiary. The greatest wealth transfer will generally coincide with the longest deferral period.

Example 1 - Mr. Jones dies at age 69, with his only child, age 47, as the primary beneficiary of his IRA. The tax law provides that the designated beneficiary shall have the right to take distributions over his life expectancy rather than an immediate lump sum distribution. This is shown below:

Example - Same facts except the IRA is a Roth IRA. This is shown below:

The key difference between these scenarios is that the Roth IRA is tax exempt. In both of these scenarios the child is the direct beneficiary of the ordinary and/or Roth IRA.

There are at least four disadvantages of having a child as a direct IRA beneficiary:

The child may accelerate IRA distributions, thus negating the benefit of deferral.

The advantage of deferral is shown below:⁸

A financially unsophisticated child may not obtain proper investment counsel. The following illustrates the benefit of higher returns in a Roth IRA:

The Inherited or Roth IRA may (in some states) be subject to the claims of creditors; or in a less common situation, the claims of one’s spouse.

A direct payment generally provides the beneficiary with a general power of appointment. This will also result in 100% of the postmortem growth being included in the estate of the decedent.

The Roth Legacy Trust^(SM) allows for multi-generational planning. The use of this trust will allow longer control of funds within the family, thus guaranteeing its availability to grandchildren.

A technical perspective

The Tax Law along with the newly proposed IRC Sec §401(a)(9) Regulations allows a Roth IRA holder to name either a revocable or an irrevocable trust as the beneficiary of a Roth IRA. When the proper procedures are followed, distributions from the Roth IRA will be paid over the life expectancy of the oldest trust beneficiary. Qualified distributions from the Roth IRA to a trust will not be subject to income taxes. If the distributions from the Roth IRA are not paid by the trustee to the beneficiary, the earnings on the distributions will be subject to income tax at trust tax rates. If the earnings are paid to the beneficiary, a DNI deduction should be available to the trust to the extent of the trust’s taxable income.

DESIGNING THE ROTH LEGACY TRUST PLAN

Single Generation Trust

The Single Generation Trust will typically be termed the Roth Legacy Trust^(SM). In the Roth Legacy Trust^(SM) the grantor (e.g., surviving spouse) is creating a Trust for the benefit of a particular child (or in some instances several children). In concept, this trust is very similar to a Standard Testamentary Trust for the benefit of a child. Under the § 401(a)(9) regulations, distributions will be made over the life expectancy of the oldest trust beneficiary. Key provisions of such a trust would be as follows:

The trustee should generally be an independent trustee.

The trust should have adequate provisions for distributions for the health, education, and future retirement of a beneficiary.

The trust should generally contain specific instructions to the trustee to take the smallest distribution under the required minimum distribution rules; unless such distributions would be distributed to a beneficiary under the education, health, and retirement scenario discussed above.

From an estate tax perspective, the planner will need to review whether the trust should contain a general Power of Appointment, vesting the trust in the beneficiary’s estate, or contain a limited Power of Appointment. Since the trust will be of a long-term duration, this will be a critical tax and practical question. When evaluating this decision, the grantor must determine whether or not the beneficiary would follow a distribution plan that would be acceptable to the grantor, or whether the grantor should simply provide that at the death of the primary beneficiary the trust will pass to specified individuals. If this occurs, we would typically be working with a Multiple Generation Trust.

The trustee should have the authority to continue the trust at the death of a child.

The trust should be very specific that distributions from the Roth IRA to the trustee will be based upon the non-recalculated life expectancy of the oldest trust beneficiary. Further, if that beneficiary dies, distributions should continue over the remaining non-recalculated life expectancy.

Distributions over a child’s life expectancy to a Roth Legacy Trust^(SM) are shown below:¹⁰

Multiple Generation Trust

In the Multiple Generation Trust the grantor is designing the trust for the benefit of several generations (typically children and grandchildren). This trust will be termed the Roth Dynasty Trust^(SM).

Distributions over a grandchild’s life expectancy are shown below:¹¹

Generation Skipping Transfer Tax Aspects

Whether you are designing a Single Generation Trust or a Multiple Generation Trust, special care must be taken to allocate GST exemption when appropriate. Generally, a trust is for a child and that child has a general power of appointment, thus it will not be necessary to allocate GST exemption. This occurs because the trust is vested in the estate of the child. However, in instances where a trust is for the benefit of a particular child, and in the event that the child dies before reaching a particular age, the trust shall pass to his or her issue, and it may be necessary to allocate GST exemption. Lastly, in those situations where a trust is strictly for the benefit of a grandchild, it will be necessary to allocate GST exemption to this trust. Furthermore, in those instances where trust is for the benefit of a child and, subsequently, grandchildren (with no intervening general Power of Appointment), generation skipping transfer tax should also be allocated.

Summary

The Roth Legacy Trust^(SM) promises to be an exciting planning technique that will be used by both wealthy and middle class families. The Roth Legacy Trust^(SM) and the Roth Dynasty Trust^(SM) both provide substantial income tax, estate tax and generation skipping transfer tax advantages. These advantages will be critical in designing estate plans in the years to come. Prior to any client making a decision not to convert at least a portion of their IRAs to a Roth IRA, they may wish to become familiar with the advantages and disadvantages of the Roth Legacy Trust^(SM) and Roth Dynasty Trust^(SM).

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Footnotes:

1Robert S. Keebler, CPA, MST is a shareholder with Schumaker Romenesko & Associates in Green Bay, Wisconsin. He is the author of the AICPA’s book on the Roth IRA titled "A CPA’s Guide to Making the Most of the New IRAs". Michael Bleck is a CPA (candidate) and Tax Associate at Schumaker Romenesko & Associates. He will be completing his Master’s Degree in Tax in May of 1998. Messrs. Keebler and Bleck are both available for consultations at 920-490-5604.

2All computations utilize Brentmark’s Roth IRA software, 1-800-879-6665.

3IRC §408A(c)(5).

4IRC §408A(c)(5).

5Instead the client’s beneficiary for property law purposes will be required to take distributions over the client and his deceased spouse’s remaining life expectancy, if any.

6Assumes a $600,000 beginning IRA balance. The beneficiary has a 35.9 year single life expectancy (age 47).

7Assumes a $600,000 beginning IRA balance. The beneficiary has a 35.9 year single life expectancy (age 47). No income tax is due on the required minimum distribution because of the Roth IRA.

8Assumes a $500,000 IRA balance. The outside account has a 10% growth rate with the growth being taxed 30%. The life expectancy of the designated beneficiary of the Roth IRA is 42.5 years (age 40).

9Treas. Reg. §1.401(a)(9)-1 Q&A E-5(a).

10Assumes the child is age 40 and the growth rate on the IRA is 10%.

11Assumes the grandchild is age 10 and the growth rate on the IRA is 10%.

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Robert S. Keebler is the author of the AICPA book, A CPA's Guide to Making the Most of the NEW IRAs.   He has also recently authored audiotapes on Planning with the Roth-Dream IRA and What the Estate Planning Attorney Should Know About Funding the Bypass Trust with Qualified Plan, Roth IRA and IRA Assets including the Newly Proposed 401(a)(9) Regulations.

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Last modified: November 27, 2001