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Mistakes People Make With Roth IRAs and Their Estate

If you have a Roth IRA, you probably already know it can be a valuable tool for estate planning, but make sure you avoid these 3 pitfalls.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

If you already have a Roth IRA, then you likely know how it can be a valuable tool for your estate plan. It’s an advantageous vehicle for building wealth — not just for yourself, but also for your loved ones. However, inheriting a Roth IRA is not without its pitfalls. That’s why we are here to explain 3 common mistakes when it comes to Roth IRAs, and how to avoid them. First, we’ll start with a brief overview of how Roth IRAs can be leveraged for estate plans. 

Why Include a Roth IRA in Your Estate Plan?

The key reason to include a Roth IRA in your Estate Plan is for its tax advantages that can be passed on to your beneficiaries. 

With a traditional IRA, you get to deduct any contributions you make from your income taxes. However, you have to pay income taxes later in life whenever you make withdrawals. When accounting for a limited retirement budget and devaluation of your money through inflation, this could be a tough pill to swallow.

In contrast, a Roth IRA lets your money grow tax-free. You have to pay taxes on your contributions upfront (by using after-tax dollars), but then you won’t have to pay any taxes thereafter. This benefit passes on to your beneficiaries as well. You, and eventually your heirs, get to withdraw from your Roth IRA without having to pay any taxes on it. Further, a Roth IRA doesn’t impose any minimum distribution requirements. That means that you can leave your money in your Roth and continue letting it grow for as long as you would like.

Some individuals may even set up a Roth IRA with no intention of using it during their retirement, and for the sole purpose of passing it on to a loved one. Be sure to check out our guide “How Roth IRAs Can Be A Great Estate Planning Strategy” to get a full explanation of benefits and how to incorporate your Roth IRA into your Estate Plan.

3 Mistakes To Avoid with Roth IRAs and Your Estate Plan

Because contributions are taxed upfront, anyone who benefits from a Roth IRA gets to enjoy its tax-free status. Additionally, minimum distributions aren’t required during the account owner’s lifetime. This allows investors to keep funds in the account so that it continues to grow. 

For these reasons, using a Roth IRA as a tool to leave an inheritance seems like a winning choice. However, if you are using a Roth IRA as an estate planning tool, or you’re a beneficiary inheriting a Roth IRA, know that there are some mistakes that can end up costing you.  

Here, we introduce 3 common Roth IRA and Estate Plan mistakes, and how to avoid them.

1. Not Naming a Beneficiary

This may seem like an obvious error to avoid, but it nonetheless happens to many Roth IRA owners. If you do not name a beneficiary to your Roth IRA, the transfer of the account upon your passing will be determined by your Will. 

At Trust & Will, we often discuss how this is a painful mistake because a Will is subject to the probate process. It can be expensive, time-consuming, and quite frankly a headache for everyone involved. Failing to designate a beneficiary is a missed opportunity. 

The moment you open a Roth IRA, be sure to name your beneficiary immediately and make updates as needed. This helps to ensure that your account will pass directly to your beneficiary upon your passing.

Also, be careful to choose the correct beneficiary. Most married couples list one another as the beneficiaries for their respective Roth accounts. When one spouse passes away, then the surviving spouse inherits the account. They can then retitle it as their own and name their child as the new beneficiary on both accounts.

2. Incorrectly Establishing a Trust

You may choose to divert your Roth IRA assets into a Trust upon your passing. This can be beneficial as long as you choose the correct type of Trust, and that your named beneficiaries are also named in your Trust. A conduit Trust could be a good option; the named beneficiary of the Trust will also be treated as the beneficiary of the Roth IRA. The Trust can also take out any required minimum distributions on behalf of the beneficiary. 

It’s best to consult a professional to select the correct type of Trust for your personal circumstances, and to set it up correctly. This is because you’ll want to make sure to lay out the terms and details pertaining to beneficiaries and distributions correctly, and to ensure that your Estate Plan is in compliance with laws regarding retirement accounts, such as the 2019 SECURE Act.

3. Not Taking Required Minimum Distributions (RMDs)

The last common pitfall is frequently made by beneficiaries. One of the most appealing characteristics of a Roth IRA is that required minimum distributions (RMDs) are not imposed. However,  this benefit is reserved for the original account owner. Because beneficiaries enjoy the tax-free advantage of a Roth IRA, they may simply assume that they won’t be subject to RMDs either.

However, under SECURE Act rule, most non-spouse beneficiaries are subject to a different set of rules. In most cases, they must withdraw all funds within a 10-year span, even with a Roth IRA. Luckily, they still get to determine the amounts and frequency in which they make their withdrawals.

Any beneficiary who fails to comply with RMDs after inheriting a Roth IRA may be subject to significant tax penalties.

Update Your Estate Plan to Include Your Roth IRA Today

Inheriting a Roth IRA offers a myriad of benefits. If you are one of the lucky few who had a spouse or parent who set up a Roth IRA with you in mind, that means you have access to funds that grew in a tax-advantaged environment. You also get to withdraw those funds tax-free as well. 

However, you’ll want to make sure that the Roth was set up in such a way that everyone gets to enjoy those benefits to the fullest. As we learned today, there are common pitfalls that can easily be avoided. Having a family game plan pertaining to the Roth IRA would be wise, such that all parties can take the correct actions. For instance, a married couple can both make sure to name one another as the beneficiary on their respective accounts. They can also share the understanding that the surviving spouse will eventually name the child as the beneficiary. Finally, the heir can be careful to comply with any laws pertaining to inherited Roth IRAs and minimum distribution requirements. 

One of the key steps to incorporating your Roth IRA into your Estate Plan is to update your estate planning documents and beneficiary designations. You may even decide to fund a Trust using your Roth IRA. Trust & Will can help you with that– take our free quiz to get started!

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