There’s a lot of focus on Roth IRAs these days. Often overlooked is that for some people, however, a Roth IRA’s greatest benefit is as an Estate Planning tool. Before making a decision, consider carefully the potential estate planning effects of the Roth IRA and add those to any income tax benefits.
While no estate will owe estate taxes in 2010 and few owed taxes under the 2009 law, converting a traditional IRA to a Roth IRA has benefits for an estate that may be subject to estate taxes after the estate tax is restored for 2011 and later years.
An IRA, whether a traditional or a Roth, is included in the owner’s gross estate. You can’t avoid that. What you can do is consider which type of IRA leaves your heirs with the most after-tax money.
When a traditional IRA is inherited, the beneficiary must include all distributions in gross income just as the original owner would have. The distributions are taxed at the beneficiary’s ordinary income tax rate. The beneficiary is able to stretch out the distributions over his or her life expectancy, but distributions are required and will be taxed.
The income taxes are in addition to any estate taxes (and don’t forget state income and inheritance or estate taxes). IRA distributions are known as income in respect of a decedent, and the beneficiary may receive a tax deduction for the share of estate taxes attributable to the IRA. The deduction shelters a small portion of the IRA distributions from taxes. After both income and estate taxes, the beneficiary is able to spend less than 100% of the IRA. How much less than 100% depends on the estate tax rate and income tax rates. Often the after-tax value of an IRA is two-thirds or less of the original value.
Suppose instead you converted a traditional IRA to a Roth IRA. The first estate tax benefit is your estate is reduced by the income taxes you pay on the conversion. Paying the taxes now reduces the size of your estate and the estate tax bill. Every traditional IRA has an embedded income tax bill that is due when distributions are made. By not converting to a Roth IRA, the embedded income taxes are included in the estate and are subject to estate taxes. So you pay estate taxes on the income taxes.
Of course your beneficiary receives more after-tax wealth, because the distributions to your beneficiary will be tax free.
Another way the Roth IRA boosts the amount your heirs inherit is that after the conversion you aren’t required to take required minimum distributions from the IRA during your lifetime. A traditional IRA is drained by RMDs each year, while a Roth IRA is intact unless you tap it to pay expenses.
Creating the Stretch Roth IRA
Unlike the original owner of a Roth IRA, a beneficiary is required to take minimum distributions over his or her life expectancy. When the beneficiary is relatively young, there is the potential for the distributions to be less than the annual earnings of the IRA, so the IRA grows while the distributions are being taken. Of course, the beneficiary can take more than the minimum, even the entire Roth IRA, at any time tax free.
When you have a Roth IRA, you want your estate planning to clearly identify who the beneficiaries are and how they will receive the IRA. If your children are mature adults, you won’t need to do more than name them as beneficiaries. They’ll inherit the IRA and manage it as they wish. You decide the percentage each will receive and put that in the beneficiary designation form.
As with traditional IRAs, when a Roth IRA has multiple beneficiaries they can decide to split the IRA into separate individual IRAs for each beneficiary. You may want to do that yourself now. Split the IRA and name one primary beneficiary for each. Or you can continue having one IRA and be sure the beneficiaries know they can split it.
More thought is required when beneficiaries are young. IRA custodians report that most IRA beneficiaries take a distribution of the entire IRA and spend it soon after inheriting it. You might want to prevent that. You also might want to take precautions when a beneficiary is not likely to manage the investments well.
In those cases, consider naming one or more trusts as beneficiary of the IRA.
Suppose Max Profits has a large IRA and names his adult children and his grandchildren as beneficiaries. He leaves 30% to each of his two children and 10% to each of the four grandchildren. The grandchildren are young. Max doesn’t want them making decisions about the money until they are mature adults. If they want to spend the money then, it’s up to them. But until then he wants the Roth IRA to compound and be a “stretch IRA” for them.
The most likely estate planning solution is to name trusts as the beneficiaries instead of the grandchildren individually. A trust is set up for the benefit of each grandchild. After the IRA is inherited, the trustee takes required minimum distributions using the life expectancy of the trust beneficiary. The distributions go to the trust. While the grandchild is young, the distributions can be paid from the trust to the parent or custodian of the grandchild. After the grandchild turns 21 or so, the trust agreement can provide the distributions are paid directly to the grandchild.
The grandchild is not able to compel distributions greater than the required minimum, though the trustee can make larger distributions when he or she deems it in the best interests of the grandchild.
Max decides that the grandchildren will be mature enough to make their own decisions about the IRA when they are 35. His trust agreements provide that after a beneficiary turns 35 the trust is terminated. The grandchild becomes direct beneficiary of the IRA. The required annual distributions are paid directly to the grandchild, and the grandchild can decide to take out more at any time.
When a trust is an IRA beneficiary the trust agreement must be carefully drafted. The tax code requires certain language for it to qualify as a “see through” trust and allow the stretch out IRA. Should the trust be done incorrectly, the ability to take only the required minimum distributions is lost. The entire IRA would have to be distributed within five years of the original owner’s death. You need an experienced attorney to draft the trust agreement, and the IRA usually must be worth $100,000 or more for the cost to be worth while. The attorney assiting with the estate planning also should be able to tell you if the trust provides some asset protection in the beneficiary’s state.
Be sure to consider the estate planning benefits before deciding which type of IRA you want.