Guide to Roth IRAs and Estate Taxes

Tax planning for your retirement accounts is an important part of setting your beneficiaries up to maximize the benefit of what you leave behind after you die. If you have a Roth IRA, you can effectively avoid estate tax issues by naming heirs as a beneficiary under the account rather than passing it through your will. This allows them to take over the account rather than inheriting it, sidestepping any potential estate taxes.

A financial advisor can help you set up your retirement accounts to reach your financial goals. 

Leaving Retirement Accounts to Your Heirs

With any investment portfolio, you can name heirs who will inherit your accounts when you die. Although the mechanics of inheriting a retirement account are different than inheriting a standard portfolio of stocks and bonds, a tax-advantaged account such as a Roth IRA works the same way when naming heirs.

Accounts that are passed through to your heirs are required, by the IRS, to liquidate an inherited retirement account within a specific amount of time, typically 10 years. The idea is that you can’t simply sit on this portfolio for generation after generation. Sooner or later someone has to pay taxes.

Additionally, if you leave retirement accounts to your beneficiaries via your will, instead of naming a beneficiary in the account itself, then the money could be liquidated. Once it is liquidated in the probate court then your heirs will have to pay tax on the dollars they receive.

Roth IRA Inheritance Rules

One of the most beneficial aspects of a Roth IRA is that there aren’t any required minimum distributions (RMDs) during your lifetime. You’ve already paid the taxes on that money so you can use those funds anytime you want in your lifetime. This makes it a great investment vehicle to transfer wealth to your beneficiaries after you die.

There are sets of rules regarding inheriting Roth IRAs for spouses, other beneficiaries and carve-outs:

Spouse Rules

When a spouse inherits a Roth IRA from her or his deceased spouse, the IRS offers four ways to handle it:

1. Spousal transfer

Provided you are the sole beneficiary, you may transfer the assets into a new IRA or your own existing IRA. The money is available at any time, but earnings will generally be taxable until you reach age 59½ and the five-year holding period has been met.

2. Open an inherited IRA (life expectancy method)

You may transfer the assets into an inherited Roth IRA held in your name. There will be RMDs, but you have the option to postpone distributions until either the date when the decedent would have attained age 72 or Dec. 31 of the year following the year of death, whichever is later.

3. Open an inherited IRA (10-year method)

You may transfer the assets into an inherited Roth IRA held in your name. The money is available at any time up until Dec. 31 of the tenth year after the year in which the account holder died, at which point all assets must be distributed. Provided the five-year holding period has been met, distributions may be taken during that period without being taxed. Otherwise only earnings are taxable. Undistributed assets grow tax-free for as long as 10 years.

4. Lump sum distribution

All assets are distributed to you and immediately available. If the account is less than five years old when the account holder dies, earnings are taxable.

Other Beneficiaries

Eligible designated beneficiaries who are not spouses must liquidate the fund within 10 years of receiving it. There are no RMDs during this time, so you can let the account continue to grow for the full 10 years before pulling all of your money out at once. Under certain conditions, you can take distributions over your lifetime.

People who are not eligible designated beneficiaries must take all the assets by the 10th year after the death of the decedent, provided that the account owner died in 2020 or later. If the person died earlier then you may open an inherited IRA and stretch distributions over your lifetime.

You will pay no taxes on this money so long as the original account owner created it more than five years before their death. If they created the Roth IRA less than five years before their death, you will owe ordinary income or capital gains taxes on the account’s growth as applicable.

Carve-Outs

Certain beneficiaries are exempt from the 10-year rule. Minor children, meaning anyone for whom you are the legal guardian, have a suspended term. They do not have to make any withdrawals while they are children but must withdraw the money from this account within 10 years of turning 18.

The 10-year rule does not apply at all to heirs who have some form of legal disability, nor does it apply to anyone who was born within 10 years of the deceased. These carve-outs don’t prevent the IRS from accomplishing its main goal of preventing the transfer of tax-free wealth from generation to generation over and over again.

You Should Name Beneficiaries to Avoid a Tax Event

No matter who you are, a Roth IRA is an excellent vehicle for avoiding capital gains and income taxes. These funds enjoy completely tax-free growth, so ideally you will only pay taxes on the money you put in originally. However, depending on how you manage your estate planning, a Roth IRA can trigger estate taxes. The rule of thumb to remember is that as soon as any assets enter your estate, they can become subject to estate taxes.

This means that if you pass any assets either through your will or probate law, estate taxes can apply. You certainly can leave retirement accounts to your heirs through a will, including a Roth IRA. This is generally done in one of two ways:

1. Leave the proceeds of your Roth IRA to your heirs: In this case, your executor would sell off the account, pay any applicable taxes and distribute the remaining money to your heirs as directed in the will.
2. You can leave the account itself: In this case, your heir would take over the Roth IRA portfolio and potentially liquidate its holdings subject to the 10-year rule as applicable.

Now, very few households are subject to the estate tax. At the time of writing the current estate tax cap is set at $12.06 million for single individuals and $24.12 million for married couples.

If your estate is worth less than the cap, then you don’t pay any taxes at all. If it’s worth more, then your estate pays taxes on the excess before making any distributions. For example, if an individual dies and passes $12.5 million on to their children, the estate will pay taxes on $440,000.

To avoid the issue altogether, however, you can name beneficiaries in your Roth IRA.

Bottom Line

The best way to pass a Roth IRA to your heirs is by naming them a beneficiary in the account. This will make sure that the portfolio never becomes part of your estate, and so never implicates issues of estate taxes because it avoids probate altogether. This gives most heirs a minimum of 10 years to distribute the funds from the account.

Tips for Tax Planning

• A financial advisor could help you put an estate plan together to protect the future of your loved ones. Finding a qualified financial advisor doesn’t have to be hard.  SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• The federal estate tax isn’t the only way that taxes can bite into your will. A few states have inheritance tax laws on the books as well that you should be aware of.

Photo credit: ©iStock.com/Zinkevych, ©iStock.com/MangoStar_Studio, ©iStock.com/PeopleImages