Discover the rules, strategies, and planning considerations for Roth IRA estate planning, which can help reduce the tax burden of your heirs.
Quick takeaways
The decisions you make about how to use your retirement savings have implications for you, of course. But if those savings become part of your estate, your decisions may have implications for your heirs.
If passed to beneficiaries, some retirement assets may come with a tax burden. Roth IRAs, however, are the exception, making them an useful tool to help you in your estate planning. Here’s what to consider.
During your lifetime, the savings you have in a Roth IRA function differently than traditional IRAs and 401(k)s. For starters, you owe no income tax when you withdraw those funds. And, you do not have to take required minimum distributions (RMDs) for Roths. Because of that, Roths often have longer time periods for potential growth.
The lack of an RMD makes a Roth IRA a good fit for legacy plans: If you don’t need the funds and leave a Roth IRA to your estate, your beneficiaries pay no penalties or income tax on distributions of either contributions or earnings. Roth IRAs may also be divided among multiple beneficiaries. Finally, Roth IRAs that are part of an estate plan do not have to go through probate (and be subject to potential probate costs).
There’s one timing catch to including Roth IRAs as part of an estate plan: While heirs don’t have to take RMDs, they must draw down the Roth IRA balance to zero within 10 years. The only exceptions to the 10-year rule are designated beneficiary exemption, which includes spouses, minor children, or disabled individuals.
The two types of IRAs don’t affect just potential income taxes; if you’re in retirement, they may affect taxes on Social Security benefits and how much you pay for Medicare premiums. For example, income tax will be due on any inherited traditional IRAs or 401(k), and those funds are counted as retirement income. Once your income reaches certain levels in retirement, some of your Social Security benefits may be taxed. And Medicare premiums are increased the higher your income is, too.
Let’s say you have some retirement savings in a traditional IRA that you may not need for your retirement, but you want to minimize the tax burden for any heirs. One option is to convert those traditional IRA funds to a Roth IRA; in that case, you’ll pay the federal income taxes, not your heirs. If your loved ones live in a state with higher income taxes, a Roth conversion may also help them even more.
Decisions around Roth IRA conversions can be strategic for both you and heirs. If you have some low income years early in your retirement, the income taxes due after a conversion may not be a burden. Or, you can space out a conversion over time.
As part of your estate plan, you can also use a Roth IRA to benefit some types of a trusts. There are tax and legal implications, and an attorney must be involved to help.
One very important detail about including a Roth IRA as part of an estate plan: If you name the estate, not a person or multiple people, as beneficiaries, the Roth IRA must go through probate. That could result in fees, potentially higher taxes, and five-year, not 10, distribution rules.
Estate planning can be complex, and the timing and strategy behind using your Roth IRA to benefit your heirs might be, too. A financial professional, tax advisor, and possibly an attorney can help you solidify your legacy goals and help ensure all your assets are used in the ways you wish.
Very few people inherit very large estates, but for those who do, inherited Roth IRAs have a couple of key considerations. The federal estate tax exemption for couples is currently $30 million; for individuals, it’s $15 million. For the purposes of estate tax value (and possible taxation), a Roth IRA is still included. Some states have a lower threshold for estate taxation; Maine, for example, taxes estates worth more than $7 million. A tax advisor can help.
If you have a Principal account, you and your spouse can also access free online resources to prepare your own will and other
