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Three Estate Planning Strategies To Build a Legacy with Roth IRA

Last update on: Jun 23 2020

You can leave your heirs the gift of almost perpetual tax free growth. That’s not a small gift, and it is one your heirs are likely to appreciate as each year passes. It is easy to include in your estate planning, thanks to Congress, and it won’t cost you much.

The estate planning vehicle you use to set up this tax-free fund is the Roth IRA. These IRAs, created in the 1997 tax law, got a lot of attention last year because that was the deadline for getting special consideration when converting a regular IRA into a Roth. What often is overlooked is that a new Roth can be a great way to leave something special for your grandchildren.

As you probably know, there is no tax benefit for creating a Roth IRA. But the Roth is not taxed, and withdrawals that meet requirements are free of both income taxes and the 10% early distribution penalty. The accumulated income and gains from the Roth IRA can avoid taxes forever, even over several owners.

Withdrawals are tax-free when the IRA is at least five years old. In addition, the distribution must be made under one of the following conditions: the owner is at least age 59½, the distribution is made after the owner’s death to an estate or beneficiary, the owner is disabled, or the distribution pays for qualified first-time home owner expenses of up to $10,000. Qualified home-buyer expenses are the reasonable settlement, financing, and other closing costs for the first principal residence of the IRA owner or a child, grandchild, or ancestor of the Roth’s owner or the spouse of the owner.

Additional benefits of this estate planning strateagy are that the owner can make contributions at any age (instead of being cut off at age 70½), and there are no required minimum annual distributions during the owner’s lifetime. Roth IRA contributions can be made when the owner’s adjusted gross income is $150,000 or less ($95,000 for single taxpayers).

Here is how you can use a Roth IRA to help your grandchild.

A person is eligible to make contributions of up to $2,000 annually to a Roth IRA to the extent he or she has earned income for the year. Suppose your grandchild pulls in a couple of thousand dollars a year from mowing lawns, baby-sitting, or a part-time job. The grandchild is eligible to contribute to a Roth IRA an amount equal to his or her earned income.

Naturally, most grandchildren are not going to contribute their earnings to a retirement fund. But the grandchild doesn’t have to contribute the actual earnings. That can be spent on videos, CDs, movies, or junk food. You can an annual gift that the grandchild contributes to the Roth IRA. The income and gains will compound tax free, and the grandchild will be able to withdraw the money tax free for qualified reasons after the five-year holding period. Even if the grandchild withdraws money when it is taxable, the tax-free compounding of the IRA is a big help.

There’s a little kicker in the Roth IRA rules that helps your grandchild. When distributions are taxable), after-tax contributions are considered to be distributed before gains. And distributions of contributions are tax-free. There are no taxes until total withdrawals exceed lifetime contributions. That means a grandchild who puts $2,000 annually into a Roth IRA might be able to pull out $20,000 tax free after 10 years and still have accumulated gains sitting in the IRA to compound tax free for the future.

There’s a second Estate Planning Strategy you can use either instead of or in addition to the first method. Use this method when your grandchild doesn’t have any earned income, you already have made the maximum tax free annual gifts, or you don’t want to give the grandchild unfettered control of a Roth IRA. In any of those cases, set up your own Roth IRA and name the grandchild as beneficiary. You’ll need earned income of at least $2,000 for the year ($4,000 if your spouse wants to do the same thing), and your adjusted gross income must be under $150,000 ($95,000 for singles).

You don’t have to take any distributions from the Roth IRA during your lifetime. After your death, the grandchild inherits the IRA and must begin required annual distributions. But those distributions will be based on the grandchild’s life expectancy. So the annual distributions should be small, will be tax free, and earnings in the IRA should be high enough to allow it to grow despite the annual distributions. Your grandchild always can take larger distributions, tax free, whenever cash is needed. (The Roth IRA will be included in your estate after your death.)

A third option is for you to convert a portion of your regular IRA into a Roth IRA, naming your grandchild as beneficiary. You’ll have to pay income taxes as though you received a distribution equal to the converted amount. After that, earnings compound tax-free, and distributions can be taken tax-free under the same conditions as for an original Roth IRA. When your grandchild inherits the Roth IRA, minimum annual distributions will be required using the grandchild’s life expectancy.

Don’t turn your attention away from the Roth IRA because your retirement is set. The Roth IRA is a great estate planning tool for older Americans, as well as a retirement planning tool for younger generations. Take a careful look at Roth IRAs and decide how they best fit into your family financial plan.



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