While individual retirement accounts typically fund one’s retirement years, you can also use a Roth IRA as an effective estate planning device for wealth transfers.
To begin, you can open a Roth IRA, or you can convert a traditional individual retirement account to a Roth IRA. During the year that you contribute to your traditional IRA, you won’t have to claim the income that you placed into the account on your tax returns. However, there is a maximum allowable contribution of $5500 for individuals under 50. Individuals over 50 can contribute up to $6500 annually.
Of course, the taxman will eventually come to collect his dues, so the money in your traditional IRA can’t remain untaxed forever. When you are within 6 months of turning 71, you must begin making minimum distributions. Those minimum required distributions are taxable as income to you. You could take maximum advantage of the tax-deferred growth by taking just these minimum distributions, and nothing more.
With a Roth IRA, there are no mandatory minimum distributions, since you make the contributions with after-tax earnings. You can allow the account to grow throughout your life, and that growth remains un-taxed.
Those you name to inherit an IRA when you die can keep the IRA as an IRA, and are not required to cash it out. These are known as Inherited IRAs. If an Inherited IRA was a traditional IRA when the owner died, then the heirs will pay income tax on the withdrawals they make after the owner’s death. If an Inherited IRA was a Roth IRA, then the heirs will take their withdrawals after the owner’s death free of income tax.
I often find confusion about inherited Roth IRAs compared to traditional IRAs. It is commonly misunderstood that because the withdrawals from a Roth are income-tax free, there is no required schedule for an heir to a Roth IRA to take money from the account. This is not true. The schedule for taking money from an inherited Roth IRA and an inherited traditional IRA are the same. The schedule is tied to the beneficiary’s life expectancy under a certain IRS table.
A beneficiary to an Inherited IRA of either type can “stretch” the IRA by taking nothing more than the minimum amount, which as stated is based on his or her life expectancy. The younger a beneficiary is, the longer an IRA can be stretched.
An IRA owner sets the stage for a “stretch” IRA with the proper designation of beneficiary(ies) at death. While this seems simple, it is anything but. When living trusts are involved, which is often the case with younger beneficairies or where it is intended that stipulations be imposed on access to IRAs by heirs, the task can be even more challenging. Even one or two words can make a difference.
Working with an estate planning lawyer trained in the rules of inherited IRAs is the best way to assure your wishes are met and there are no unintended results. Especially with a Roth IRA which if properly set up can leave an inheritance that can fund a retirement without income taxation.