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Estate Planning with Roth IRAs

As Roth usage increases, so do questions about best estate-planning practices for these accounts.

Natalie Choate, 11/11/2011

Natalie Choate will be speaking at a location near you if you live near Waltham, Mass. (6/1/12); Minneapolis, Minn. (11/14/11); St. Charles (11/15/11) or Chicago (5/1/12), Ill.; Memphis, Tenn. (12/1/11); Cincinnati (2/10/12); Overland Park, Kan. (5/3/12); Spokane, Wash. (5/8/12); or Evansville (11/16/12), Indianapolis (6/8/12), or South Bend (9/20/12), Ind. See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.

Since the "income cap" was lifted on Roth conversions in 2010, more and more clients have Roth IRAs. It's time to consider where those assets should be placed in the estate plan.

By the way, please send in some questions! My supply is running low!

Question: I read in a financial publication that giving away a Roth IRA is "a good planning idea." Several other articles are out there about this strategy. Does it really work?
Answer: No. You cannot give away a Roth IRA. Or rather, you can do so, but giving it away would cause it to cease to be an IRA. The gift-transfer would be treated as a complete distribution of the account to the donor, followed by a gift of the proceeds to the transferee. The deemed distribution might be tax-free (if the donor meets the requirements for a "qualified distribution"), but there will be no further tax-free accumulation because the Roth ceases to exist.

A "Roth gift" strategy that does work is for a donor (typically the parent of a teenager) to open a Roth IRA for the donee (the teenager). Example: Teenager earns $5,000 in a summer job. Teenager therefore has compensation income, and if his income is low enough, he is entitled to contribute to a Roth IRA. The parent and teen can open the account together in the teen's name and the parent contributes $5,000 to it.
Both of these strategies are discussed in ΒΆ 5.8.06(C), "Gifts with Roth IRAs," of my book Life and Death Planning for Retirement Benefits (7th ed. 2011).

Question: "Duncan" wants to leave some of his assets to charity, some to his wife, and some to his children. He has some assets in a traditional retirement plan, some in a Roth plan, and some in outside (nonretirement) investments. Which asset should he leave to which beneficiary?

Answer: With a traditional IRA, all three of Duncan's proposed beneficiaries are considered "tax-favored" choices for income tax purposes: Children (or other young people) because of their long life expectancies (facilitating a long tax-deferred "stretch" payout), the spouse (because she can roll over to her own IRA), and charity because it is income tax-exempt. In Duncan's case, leaving the traditional plan to charity is very appealing, since the charity (unlike the wife and children) can receive these retirement plan benefits income tax-free.

With the Roth plan, the picture changes slightly. Charity is not an income tax-favored choice of beneficiary for a Roth plan. Because distributions from a Roth plan are generally income tax-free anyway, there is no advantage to leaving this asset to an income tax-exempt entity. Thus, Duncan should leave the Roth plan either to his spouse or to the children.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.
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