- Naming a Roth IRA beneficiary is critical to make sure the money you saved goes to the family members you intended with the most tax benefits possible.
- You can leave a Roth IRA to a beneficiary tax-free, as long as you have owned the account for more than five years.
- Your beneficiaries can stretch out the distributions from a Roth IRA over their lifetime, which is a significant tax benefit.
Introduction: How you can name beneficiaries
A Roth IRA can be a fundamental part of your estate plan. But, none of its benefits can be used if you do not complete your beneficiary designation. When you open a Roth IRA, you fill out a form that names the person(s) who inherit your account after you die: your Roth IRA beneficiary. This form is more important than many people realize. They leave it blank or leave their Roth IRAs to their estates, which can create complications and cost tax savings.
Roth IRAs are particularly valuable as an estate-planning tool. Traditional IRAs require owners to begin taking required minimum distributions (RMDs) at age 70½. As you draw down that Traditional IRA, you are required to pay taxes on the money you take out. With a Roth IRA, there are no required distributions and all the distributions you do take are tax-free. That means you can leave your money in a Roth IRA and allow it to grow and be passed along to your heirs.
Naming beneficiaries gives those people the most tax advantages possible. In this article, we’ll explain why and outline the best practices.
- Why Designate a Roth IRA Beneficiary?
- How Do You Name a Roth IRA Beneficiary?
- What Are the Tax Implications of Bequeathing a Roth IRA?
- How Many Beneficiaries Should You Have?
- Whom Should You Name as a Roth IRA Beneficiary?
- How Often Should You Update Your List of Beneficiaries?
If you designate a beneficiary, any Roth IRA assets that have not been distributed to you will be passed automatically to the heirs that you select (usually, a spouse or children). If you don’t designate a beneficiary, your unused retirement assets get lumped into your total estate and will be divided according to the laws in your state. Your spouse or your children may then end up with the money, of course, but when you leave it to them that way, they won’t have access to the same tax benefits they would have if you had named them as beneficiaries.
Also, by letting the IRA funds enter your general estate, you leave open the potential for other relatives to lay a claim to those funds – and they might get it, depending on the prevailing state laws (unless you specifically stated otherwise in a will). In other words, it can open your estate up to be contested by heirs who may have been left out for one reason or another.
When you designate a beneficiary for your Roth IRA, you are essentially entering into a formal contract with the company that manages your Roth IRA. This custodian is bound contractually to follow your beneficiary designation form to the letter, ensuring you have ultimate control over who will get your money when you die.
Problems with Probate
Contracts like these (similar to ones that carry out your life insurance policy payouts) have the benefits of skipping the probate process that estates normally go through. Having your assets tied up in probate court after your death can eventually reduce your total estate’s net worth by as much as 20%, due to lawyers’ fees, court costs, appraisals, and other costs.
In addition, probate is a very time-consuming affair. It can take months for all of your assets to pass through probate and be distributed to your heirs after your debts are paid. What if your family needed money immediately after your death? What if you were the primary breadwinner – how would they function financially? Designating a beneficiary to your Roth IRA and allowing that money to skip the time consuming probate process will give your heirs immediate access to funds.
The process varies by IRA custodian, but naming a Roth IRA beneficiary is usually pretty simple. You can frequently specify multiple beneficiaries and then set the bequests as percentages of the account or even fixed amounts. In addition, many custodians will allow you to specify generic categories, such as “To the person I am married to at the time of my death,” versus stating a specific person who might be your wife at the time.
Here is a sample of one designation page:
If you leave your Roth IRA to your spouse, he or she will receive it and can basically treat it as his or her own. Your spouse won’t be required to take distributions or have to pay taxes.
If you name one or more people other than your spouse as a beneficiary, they will need to withdraw a minimum amount each year. You will find worksheets for IRA distributions here. There are several methods for calculating how much they withdraw. The benefit of the Roth IRA, compared with the Traditional IRA, is that your beneficiaries do not pay income tax on the distributions as long as you held the account for more than five years.
Your beneficiaries can also control the amount of distributions and the time over which they take them, depending on how they do the calculations. Stretching out the IRA gives the funds decades of tax-free growth in a Roth IRA.
There is no limit on the number of beneficiaries you can have. How many you should have is a matter of choice.
Most people name their spouses first. Children are frequently named next. If you are not married, you can name any person. Note that because of the rules that enable people to stretch out distributions of an inherited Roth IRA, the people who benefit most are young.
Experts advise checking your named beneficiaries at least once a year, perhaps at the same time you rebalance your investments. It’s easy to accidentally leave family members out if you set one up when you first had children, for instance, or if you have recently remarried and have a new spouse. You also may need to update the form if a parent or elderly relative you named as a beneficiary has passed away.
You can mark the date you reviewed your form on your calendar and program in a recurring reminder to update it once a year.