6 minute read

How Roth IRAs Can Be a Great Estate Planning Strategy

Roth IRAs are not only a great way to plan and save for retirement, but they're also a sound estate planning strategy. Trust & Will explains how.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

We all know by now how important it is to save up for retirement, and to start saving early. There are many retirement savings options available to choose from, such as a 401(k), an individual retirement account (IRA), mutual funds, and other types of investment accounts. Today, we’re going to talk about a special type of IRA - the Roth IRA. What makes this type of retirement account unique, and why is it a great estate planning tool? Keep reading to find out.

What is a Roth IRA?

A Roth IRA is a type of individual retirement account that sets itself apart from traditional IRAs in the way that it gets taxed. When you contribute to a Roth IRA, you do so by using your after-tax dollars. This means that these contributions aren’t tax-deductible. When you start making qualified withdrawals from your Roth IRA, the money is tax free.

If you were to select a traditional IRA, you would contribute pre-tax dollars into your account. Your qualified withdrawals would be taxed later down the line. This is the major distinction between Roth IRAs and traditional IRAs. 

This begs the question of whether you’d want to pay taxes on your retirement funds today or tomorrow. Let’s discuss the benefits of a Roth IRA to help you decide on your preference.

What Are the Benefits of a Roth IRA?

According to the Tax Policy Center, 10 percent of American taxpayers own Roth IRAs. Introduced in 1997, the Roth IRA is relatively new to the retirement savings market when compared to other retirement savings products that have been around for decades longer. This means that most Americans opt for a traditional IRA or 401(k) by default, but may be missing out on the myriad of benefits offered by the Roth IRA.

Here they are below:

  • Get your retirement income tax-free: The most common reason people reach for the Roth IRA over a traditional IRA is the opportunity to get your retirement income tax-free. A traditional IRA offers instant gratification in the sense that you can deduct your contributions from your income taxes. However, you must pay income tax when you pull money out of your IRA in retirement. This could be quite painful when taking inflation into account. Conversely, with the Roth IRA, you must be patient for your reward. While you’re making contributions in your earning years, you do so using your post-tax dollars. This means that you can’t deduct your contributions from your taxes and don’t get any tax benefits in the meantime. It’s when you retire when the magic finally happens, and it’ll be well-worth the wait. When you make withdrawals from your Roth IRA in retirement, you’ll enjoy your funds without owing anything to the IRS.

  • Your emergency fund has an emergency fund: Ideally, you’ll tuck away your acorns and create a sizable nest egg for retirement. However, there could be times in your life when you have to tap into your retirement savings, such as to help pay for an emergency. Luckily, early withdrawals are easier through a Roth IRA. A traditional IRA charges a 10 percent early withdrawal penalty and an income tax bill. A Roth IRA does not, as long as your withdrawal is from your contributions and not your earnings. If you find yourself in a financial pinch and don’t have a separate emergency fund at the time, it makes more sense to withdraw from your Roth over your traditional IRA account.

  • Let your investments grow no matter your age: Required minimum distributions (RMDs) are imposed by certain retirement accounts. This means that savers are required to withdraw from their accounts by a certain age (usually 72), or they face a hefty 50 percent tax fine from the IRS. If you haven’t guessed it already, a Roth IRA is RMD-free. This means that you get to keep your money in your Roth as long as you’re alive. This also means that your money can continue growing tax-free as long as you’d like. You won’t be forced to withdraw money at an inopportune time, such as when your assets aren’t performing well due to market conditions.

  • Beneficial for your heirs: Are you setting up a retirement account with your loved ones in mind? You might rejoice to find out that your heirs get to inherit your Roth IRA tax-free. This is quite the advantage compared to a traditional IRA or 401(k) where withdrawals made by heirs are taxed. In other words, you get to pass your Roth IRA benefits directly down to your heirs.

  • Accessible: Last but not least, almost anyone can contribute to a Roth IRA. Currently, your adjusted gross income must be under $140,000 if you’re filing single, or $208,000 if you’re married and are filing jointly. Are you over the limit? Luckily, there’s a workaround. In a technique called the backdoor Roth IRA, you can convert an existing traditional IRA into a Roth IRA. You will have to pay income taxes on any contributions that are deductible, plus on any investment gains, but you still get to reap the benefits of the Roth. 

Why Are Roth IRAs a Great Estate Planning Tool?

Estate planning is the act of securing our futures, and planning for our retirement is very much a part of this process. Earlier, you learned that you can build up your savings in a tax-free environment via the Roth IRA and make those withdrawals tax free during retirement. 

Not only are Roth IRAs a great way to save for the future, they offer several estate planning advantages. The benefits are magnified the more wealth you can build in your account. Below you’ll find a discussion on Roth IRA estate planning, broken up into sections for each benefit.

Roth IRAs have historically low tax rates

If you’re thinking about converting your traditional IRA into a Roth IRA, now could be an opportune time. Tax rates are at historically low levels right now (subject to change under the Biden Administration), which means that you’ll pay less taxes on your conversation.

By converting now, you can make sure to take advantage of a future opportunity cost when tax rates could go up. You can also strategically convert an amount that will allow you to fill up your current federal tax bracket. 

Roth IRAs are not subject to required minimum distributions

As mentioned earlier, Roth IRAs are not subject to required minimum distributions (RMDs). This makes Roths a malleable tool for your estate plan, because your circumstances can always change. We can only do our best to plan for the future, but our realities can change drastically by the time the future arrives.

By choosing a Roth IRA, you’ll feel more empowered when you enter your retirement years. You won’t be forced to withdraw funds from your account if you want to keep growing your money in a tax-advantaged environment, or if you don’t want to sell assets when market conditions aren’t favorable. You can withdraw from your Roth whenever you please, and you don’t have to do so at all if you don’t want to. 

Roth IRAs provide tax diversification

A Roth IRA can also help you access new options to diversify your taxes. 

Let’s say that you own a traditional IRA, a 401(k), and a Roth IRA. This is not an uncommon scenario; each type of retirement savings account offers its unique benefits. Some savvy savers might decide to take advantage of all three and spread out their risks and benefits.

Retirement could be years or decades from now, and it can be so uncertain what the economic environment will look like. Will social security even be a thing? What will be the tax rate? Will they still impose minimum distribution requirements? These are all questions that we can’t answer now. Thus, it can be a good idea to spread out your risk. Because Roth IRAs allow you to withdraw your funds tax-free, they can provide you with greater peace of mind. In case the tax rate happens to be sky-high when you retire, you’ll be glad knowing that you paid some of your taxes upfront.

Assets in a Roth IRA grow tax-free for the account holder’s beneficiaries

Perhaps you don’t set up your Roth IRA for your retirement at all. Maybe you set it up with your heirs in mind. Just like with any type of retirement or savings account, you get to make your beneficiary designations for your Roth IRA. 

Because you are contributing funds with post-tax dollars, any future withdrawals won’t be taxed. This also means that your investments are growing in a tax-free environment for your beneficiaries.

Roth IRAs allow you to pass along as much wealth as possible to your heirs 

The benefits of using a Roth IRA as an estate planning tool grew substantially with the Setting Every Community Up for Retirement Enhancement (Secure) Act. This Act eliminated the stretch IRA for any IRAs inherited by non-spousal beneficiaries. This means that these beneficiaries have to withdraw the entire IRA within 10 years of receiving the inheritance.

Although Roth IRAs are also subject to this rule, the withdrawals can be made tax-free.  This makes the Roth IRA even more appealing relative to traditional IRAs in the context of estate planning. They’re an ideal tool especially when you have beneficiaries that aren’t your spouse. 

How to Set Up Your Roth IRA as an Estate Planning Tool

If you feel convinced that the Roth IRA is a great estate planning tool, you may be wondering how to go about setting up your Roth IRA such that it can be incorporated as a part of your Estate Plan.

Here are some simple steps to follow:

  1. Set up and fund a Roth IRA, or convert a traditional IRA, if you don’t already have one.

  2. Designate your spouse as your named Roth IRA beneficiary.

  3. Update your estate planning documents to reflect this new asset and explain that your spouse is the designated beneficiary. Include the instructions that if they survive you, your spouse will treat the account as their own by re-titling it in their own name. 

  4. Your surviving spouse names your child as the new named beneficiary for your Roth IRA.

  5. Your child must begin taking minimum distributions by the end of the year following your spouse’s death.

The steps above illustrate an example in which two spouses took advantage of Roth IRA rules such that eventually the tax-advantaged annuity is passed on to their child. However, there can be various estate planning scenarios, and thus various tax and legal considerations. It’s always best to consult a professional. 

Update Your Estate Plan to Include Your Roth IRA Today

A Roth IRA is a special type of individual retirement account that offers several advantages. For starters, you contribute after-tax dollars into your account and get to make tax-free withdrawals in retirement. This means that your investments also grow over time in a tax-free environment. Most retirement accounts force savers to make minimum withdrawals by a certain age. Again, the Roth IRA is advantageous because minimum withdrawals are not required. Thus, they can be a great estate planning tool. Although you may choose to make some withdrawals for yourself, you can also plan to leave most or all of your investment savings (which continue to grow) and bequeath them to a loved one. By putting off instant gratification and contributing after-tax funds, both you and your family get to enjoy tax-free withdrawals in later years.

Are you ready to set up a Roth IRA and leverage it as an estate planning tool for your legacy? Don’t forget to update your estate planning documents! Whether you decide to add a new asset or change your beneficiary designations, Trust & Will takes away any frustrations by simplifying the estate planning process. Better yet, you can do it all online! We want to make it as seamless as possible such that you don’t hesitate to make changes that would benefit you most. Click here to find out how to get started.

Is there a question here we didn’t answer? Reach out to us today or chat with a live member support representative!