Save Taxes Even After You’re Gone

Estate Planner Jan-Feb 1999

Roth IRAs Permit Tax-Free Growth for Beneficiaries Too

By creating the Roth Individual Retirement Account (IRA), the Taxpayer Relief Act of 1997 gives your money a way to grow tax free — not only while you’re alive but also after you’re long gone. While contributions to Roth IRAs are not tax deductible, qualified distributions from them are not included in gross income. This means the growth of the assets in a Roth IRA is not subject to income taxes.

As with traditional IRAs, if beneficiaries do not need the Roth IRA funds, you should defer distributions as long as possible. For traditional IRAs, deferral postpones the payment of built-in taxes. For Roth IRAs, deferral lets the assets continue to grow tax free even after your death.

Post-Death Distributions

Post-death distributions from Roth IRAs are subject to the rules governing distributions from traditional IRAs and to the terms of the agreement. Two options generally are available for a nonspouse beneficiary: Distributions must be made either over the beneficiary’s lifetime or by the end of the year after the fifth anniversary of the account holder’s death. Lifetime payments must begin by the end of the year after the holder’s death. Unless you need the assets sooner, you should choose the lifetime payment option to continue the tax-free growth of the assets as long as possible.

If the beneficiary is the Roth IRA holder’s spouse, special rules apply. The surviving spouse may treat the Roth IRA as his or her own, or may roll it over into his or her own Roth IRA. Whether the spouse treats the Roth IRA as his or her own or rolls it over, the tax-free growth will continue during his or her lifetime without any required distributions — even after age 70 1/2. The spouse can also name his or her own beneficiary, thus further continuing the tax-free growth of the assets.

Check the Roth IRA agreement carefully to determine if its distribution provisions are more restrictive than those stipulated by law. The agreement may not contain all available options. For example, a Roth IRA agreement may require that post-death distributions be made within five years of the Roth IRA holder’s death, not over the beneficiary’s lifetime. This would limit the income tax-free growth of the assets.

If the beneficiaries need additional funds, the Roth IRA can provide a source of income tax-free money. Distributions to beneficiaries made after the death of the individual Roth IRA holder are not included in gross income if the account has satisfied the five-year holding requirement.

Estate Planning Implications

Under traditional IRAs, the holder may take into account the effect of income taxes on the beneficiaries in determining how to divide assets among them. For example, the holder may provide additional assets to the beneficiary of a traditional IRA to offset the disadvantage of the built-in income taxes. Under a Roth IRA, the beneficiary has the advantage that any growth of the asset is income tax free.

Because Roth IRAs can grow tax free, you should ensure they won’t need to be liquidated to pay estate taxes. One way to make liquidity available to your estate is to purchase life insurance through an irrevocable trust.

Creating a trust to hold the Roth IRA proceeds after the holder’s death may also be advantageous. The trustee can defer distributions for as long as practical to increase assets for beneficiaries who would otherwise withdraw the proceeds too quickly. If there is significant age disparity among beneficiaries, you could use multiple trusts. Otherwise, payments will be based on the life expectancy of the oldest beneficiary.

Benefits Can Continue Long After Death

With careful planning, the tremendous income tax-saving benefits of Roth IRAs can continue long after the death of the holder. Please let us know if you have any questions about post-death distributions from a Roth IRA. We would be glad to help you take advantage of this opportunity to have your money grow tax free long after you’re gone.