Payout options for Roth IRA beneficiaries
Last week's column looked at options for a surviving spouse as a Roth IRA beneficiary. This week we turn to other kinds of beneficiaries.
Roth IRAs do not have minimum distribution requirements during the account owner's lifetime. Age 70½ can come and go and no distributions are required. This allows more wealth to accumulate tax-free as the assets stay in the Roth IRA and earnings are reinvested tax-free. Roth IRAs are a great tool to consider in estate planning. Inheriting a Roth IRA is a wonderful thing for a beneficiary.
An individual (other than the spouse of the account owner) has two options for his or her inherited Roth IRA:
(1) Take minimum distributions over the beneficiary's single life expectancy or
(2) Withdraw all assets from the account within five years.
In both cases, if the distributions are qualified, that is, the assets have been in the Roth for at least five years, the beneficiary will owe no income tax. Non-spouse beneficiaries cannot roll over the funds into their own Roth IRA or treat it as their own.
Caution: While the Roth IRA beneficiary does not pay income tax, the Roth IRA is subject to Pennsylvania inheritance tax and federal estate tax.
Liquidating the account within five years of the death of the account owner limits the time period available for tax-free growth in the account. That tax-free growth plus the tax-free distributions is what makes the Roth IRA so valuable.
Choosing the option to take minimum distributions over the lifetime of the beneficiary allows for more tax-free wealth accumulation. If the Roth beneficiary is young a person, using the beneficiary's remaining life expectancy could allow the account to continue to grow tax-free for as much as 70 years instead of only five years. This potential tax-free growth makes families and planners celebrate. Remember, the beneficiary can always withdraw more than what is required, just not less than what is required - the required minimum distribution.
If the minimum distribution option is selected, distributions must begin before the end of the calendar year following the year of death. If they do not, then distribution will have to be under the five-year rule. It is very important that the deadline be watched carefully.
If there are multiple beneficiaries, for example, the group consisting of the account owner's children or the account owner's grandchildren, determining the amount to be distributed as a required minimum distribution (RMD) is difficult. If all of the beneficiaries in the class are people (and not an organization such as a charity) and if separate accounts are not divided and set up for each beneficiary, the life expectancy calculation used for the RMD is based on the beneficiary with the shortest life expectancy. This could be a great disadvantage to younger beneficiaries.
Sometimes a beneficiary will disclaim, that is, refuse to accept the benefit. A qualified disclaimer must be made within 9 months of the death of the account owner. Sometimes beneficiary designations are a mess, and they need to be repaired using disclaimers and, perhaps, by paying some beneficiaries a lump sum so that other beneficiaries can use the lifetime stretch-out. The beneficiaries must be finally determined in any event by September 30th of the year following the decedent's death.
If separate accounts are set up, then the RMDs for the separate accounts are calculated individually based on each beneficiary's actual life expectancy. Separate accounts must be established on or before December 31st following the year of the account owner's death. However, keep in mind that the September 30th is the date to finalize designated beneficiaries, so some beneficiaries need to make sure that separate accounts are created by the earlier September 30th due date. Separate accounts not only allow different life expectancies to be used for RMDs but allow for different investments in each account, and any beneficiary's account can be moved to the financial institution of his or her choice.
If Roth IRA beneficiaries are minors, the designation should either be to a custodian under the Uniform Transfers to Minors Act for the benefit of that minor or to a trust for the minor. Complicated rules apply in order to create a trust that will permit the trustee to withdraw RMDs over the lifetime of the trust beneficiary.
This is an extremely complicated area of the tax law. Beneficiary designations on traditional IRAs as well as Roth IRAs are an important part of estate planning. The design of the beneficiary designation should be prepared by your estate planning attorney.
It can be very frustrating when the beneficiary designation form gives you only a short line to insert a name when the plan holds a large portion of your assets and you need to provide for contingencies and insure the best tax treatment. Many custom beneficiary designations are attached as separate pages. Preparing this designation is just as important as making your will. Make sure you get qualified advice.