As Roth usage increases, so do questions about best estate-planning practices for these accounts.
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 ¶ 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.
If federal estate taxes are a concern, there is a strong argument against making the traditional IRA payable to the children. By inheriting the traditional IRA, they would be inheriting an asset that has a built-in income tax "debt." Duncan does not get a marital or charitable deduction for leaving assets to his children; the only estate tax "shelter" there is for bequests to his children is the federal estate tax exemption. Part of that exemption is "wasted" if the children inherit an asset that they then have to pay income tax on--part of the "exempt" amount goes to the IRS. So the children should inherit either the Roth plan or the nonretirement assets; either way, they will owe no income tax on their inheritance.
We have figured out that the charity should inherit the traditional retirement, and the children should not inherit it; that leaves the Roth plan and the nonretirement assets to be divided somehow between the spouse and the children. The question is, what is the best income tax scenario for the Roth plan?
If a Roth IRA is left to the children, they can stretch it out via annual tax-free distributions over their life expectancies. That's a pretty darn good scenario.
But if the Roth plan is left to the surviving spouse, she can get an even better scenario: She can roll the inherited Roth plan over to her own Roth IRA (only the surviving spouse has this right). Then she will be able to stretch out the tax-free distributions much longer than the children possibly could: She does not have to take any minimum required distributions at all from the rollover Roth IRA during her lifetime. After her death it can be left to the children for gradual tax-free distributions over their life expectancy.
Duncan's choice is made: Leave the traditional retirement plan to the income tax-exempt charity, the Roth plan to the wife for her to roll over and keep accumulating tax-free, and the nonretirement assets to the children.
Resources: For all details regarding Roth retirement plans, including who is eligible to contribute (and how much), income tax treatment of Roth distributions, and minimum distribution requirements for Roths, see Chapter 5 of Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011), which can be ordered for $89.95 plus shipping through www.ataxplan.com or Amazon.com, or by calling 800-247-6553.