4 Mistakes Clients Make With Roth IRAs and Their Estate

Roth IRAs are popular accounts that investors can leave to their heirs due to the tax-exempt status of these accounts and lack of required minimum distributions (RMDs) during the lifetime of the original owner.

Roth contributions are made with after-tax money, and any distributions you take are tax-free as long as you are at least 59½ years old and have had a Roth IRA account for at least five years.

Your beneficiaries can enjoy this tax-exempt status for some time after they inherit the account. However, they will not be able to maximize their tax savings with the Roth account unless it is properly passed on. Here’s what you need to know.


Key learning points

  • By leaving your Roth IRA to your heirs, you can provide them with tax-free income for years to come.
  • Be sure to designate your beneficiaries when you open the account and change them in the future if necessary.
  • If you intend to use a trust, consult a financial or legal professional who is familiar with the rules.

A tax-free inheritance

Roth IRAs can provide beneficiaries with a lasting, tax-free gift. Scott Sparks, a wealth management consultant at Northwestern Mutual in Denver, Colorado, said: The Wall Street Journal“From an inheritance point of view, it is one of the more beneficial gifts a person can pass on to the next generation.” With that and other benefits for the account holders themselves, it’s no wonder Roth IRAs have become one of the most popular ways to save for retirement.

Pitfalls to Avoid

There are also some potential mistakes that you should be aware of and avoid if you want to pass your account on to the next generation. According to financial advisors, the most common mistakes are the following.

Do not name a beneficiary

This is probably the most obvious mistake a Roth IRA owner can make. If you do not specify a beneficiary, the account transfer can be determined by your will, which can be complicated, costly and time consuming. Roth IRA owners must name their beneficiaries as soon as they open the account, and change them, if necessary, in the future.

This way you can be sure that the money ends up in the account with the person for whom it is intended. Most financial institutions have separate Roth IRA beneficiary forms that you must complete.

Choosing the wrong beneficiary

Married couples usually list each other as the main beneficiaries of their Roth accounts. When one of the spouses dies, the other spouse inherits the money. It is then passed on to another beneficiary upon the death of the second spouse.

Thanks to SECURE Act, most non-spouse beneficiaries can extend benefits over a decade. Secure Eligible Designated Beneficiaries distributions even further. In addition to the surviving spouses, these include disabled or chronically ill individuals, individuals who are not more than 10 years younger than the IRA owner, or a child of the IRA owner who has not yet reached the age of majority.

Bobbi Bierhals, a partner at the McDermott Will & Emery law firm in Chicago, said: The Wall Street Journal that “by far the greatest benefits of the Roth IRA after death are tax-free growth in the account and the fact that distributions can be made with no income tax implications.”

However, leaving a Roth to a younger beneficiary can in some cases lead to inheritance or transfer taxes that skip generations, so it’s worth consulting a finance professional who is familiar with the rules.

Incorrectly establishing a trust relationship

It may be a good idea to put your Roth assets into a trust after your death, as long as you have the right type trust and your beneficiaries are specifically named in the trust. A trust leadership records the beneficiary’s required minimum benefits (RMDs) each year. With a conduit trust, the person or entity designated as the beneficiary of the trust is treated as the direct beneficiary of the Roth IRA.

However, the trust documents must describe all the details regarding the benefits and beneficiaries. Otherwise, the IRS may require the trust to distribute all income in the account within five years, rather than the usual 10 years. This is another area where it is advisable to seek professional help.

Let your beneficiaries know that while you didn’t have to take required minimum distributions from your Roth IRA, they generally will.

Neglecting to take the required minimum distributions (RMDs)

This is a mistake beneficiaries can often make. Under SECURE Act rules, most non-spouse beneficiaries have up to 10 years to fully disperse all funds in an inherited Roth IRA. There is no fixed RMD in a year for this one designated beneficiariesand they can choose the frequency and timing of recordings. However, the account must be fully used by December 31 of the tenth year after the death of the account holder.

For those who fall into any of the eligible designated beneficiaries listed above, RMDs must begin as early as December 31 of the year after the account holder’s death. If the beneficiary does not do this, there may be: significant tax fines due to non-compliance with the RMD rules.

What happens if I forget to designate a beneficiary on my Roth IRA?

If you do not designate a beneficiary on your Roth IRA, the probate court will look at the designation in your will. If you don’t have a will, state laws determine the beneficiary of your Roth IRA, usually next of kin.

Do I need to update my Roth IRA beneficiary with my account custodian after a divorce?

Yes, you must update your Roth IRA beneficiary directly with your account manager. Even if your divorce decree pertains to your beneficiary situation, it’s still important to go straight to the source. The beneficiary listed on your retirement account is considered above any will or trust document.

How can I set up a trust to make sure my beneficiary doesn’t squander their inheritance?

You can set up a conduit trust, which identifies the annual distributions for the intended beneficiary. Following the SECURE Act, most beneficiaries will have to withdraw all funds within a 10-year period. This is true even if you have a trust that will distribute the money over time. If your intended beneficiary does not fall into one of the eligible categories of designated beneficiaries, you should talk to a financial advisor about how to set up a trust to most effectively address your concerns.

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