Beneficiary designations for Roth IRAs, Pt. 2

By Jason Kestler

Kestler Financial Group, Inc.


In part one, I discussed ​several taxs and nontax points to consider when choosing a beneficiary. In part two, I'll delve into further options, including trusts and charities.

Special options available to spousal beneficiaries

Special distribution options may be available to surviving spouse beneficiaries (discussed below).

Your options when choosing Roth IRA beneficiaries
Who can you designate as your Roth IRA beneficiary? Basically, you have the same options that the owner of a traditional IRA has. Because Roth IRAs are different from traditional IRAs, though, some special considerations may apply. Your beneficiary choices generally include the following options:

Tip: For general information on multiple beneficiaries, primary and secondary beneficiaries, "designated" beneficiaries versus "named" beneficiaries, and other issues, see our separate topic discussion, Beneficiary designations for IRAs and retirement plans.

Surviving spouse
If your surviving spouse is the sole designated beneficiary of your Roth IRA, he or she will have certain options that are not available to other types of beneficiaries. For instance, your surviving spouse can generally elect to be the new account owner of the inherited Roth IRA. Alternatively, your surviving spouse can generally elect to roll over the inherited funds to his or her new or existing Roth IRA. In either case, the inherited funds will be in a Roth IRA in your surviving spouse's own name. (Other types of beneficiaries must withdraw from the Roth IRA that is in your name.) This outcome is significant for two reasons:

As a Roth IRA owner, your surviving spouse can name new beneficiaries of his or her choice (your children, for example). These new beneficiaries will receive the funds remaining in the Roth IRA after the death of your surviving spouse. By having new beneficiaries, the period of time for the tax-free accumulation of earnings in your Roth IRA is extended (subject to the post-death RMD rules, of course).

Caution: You may not be happy that your spouse has this discretion to change beneficiaries, especially if you have children from a prior marriage or you are concerned that your spouse might remarry and name the new spouse as the primary beneficiary.

As a Roth IRA owner, your surviving spouse will not be subject to the lifetime RMD rules. He or she can take distributions from the account if desired, but there is no requirement that he or she do so. This creates the opportunity to preserve the funds in a tax-advantaged environment for the new beneficiaries.
Of course, these are not the only options available to a surviving spouse beneficiary. Your surviving spouse can also elect to disclaim the inherited Roth IRA funds, or take post-death distributions under the life expectancy method or the five-year rule. In most cases, though, it will be in a surviving spouse's best interest to exercise one of the unique spousal options.

A child, grandchild or other individual
You may want to name your child, grandchild or other individual as the beneficiary of your Roth IRA. As mentioned, a non-spousal beneficiary must take the Roth IRA distributions in one of the following two manners:
  • By the end of the year during which the fifth anniversary of the account owner's death occurs, or
  • Over the remaining single life expectancy of the beneficiary, with the first distribution starting no later than December 31 of the year following the year that the account owner died
If you designate a grandchild or other young beneficiary for your Roth IRA, he or she may be able to take post-death distributions over a long payout period using the life expectancy method. This could maximize tax-advantaged growth opportunities by allowing some of the funds to stay in the Roth IRA for many years. And unlike a traditional IRA post-death Roth IRA distributions may be free from income tax.

Caution: If you name your grandchild as IRA beneficiary and have a substantial estate, the generation-skipping transfer tax (GSTT) may be an issue. Before naming any beneficiary, consider consulting a tax planning or estate planning professional for more information.
A trust
You can name a qualifying trust as the beneficiary of your Roth IRA if the IRA custodian or trustee allows such a designation. If all requirements are met, the beneficiaries of the trust can be treated as the designated beneficiaries of the Roth IRA. When a qualifying trust is the beneficiary of a Roth IRA, post-death distributions are calculated based on the life expectancy of the oldest trust beneficiary, which can reduce the time that distributions can be spread out.
Suppose, for example, you name your 70-year-old brother and your 10-year-old grandchild as co-beneficiaries under a trust. For distribution purposes, your grandchild must use your 70-year-old brother's life expectancy since your brother is the oldest beneficiary. Therefore, your grandchild will lose the deferral of payouts that could occur if his or her life expectancy were used instead. Still, a trust can be an especially useful tool if you want your children (or other individuals) to benefit from your Roth IRA, and you want to maintain some control over their access to the funds.

Tip: You may be able to establish separate trusts to enable each beneficiary to use his or her life expectancy when calculating required post-death distributions. Consult an estate planning attorney.

Caution: There are costs associated with establishing and administering a trust, including the cost of retaining an attorney for advice and to draw up the trust agreement.

A charity
You may name a charity as the beneficiary of your Roth IRA. Such a move may be especially attractive if you don't have any loved ones, or if you want to benefit your loved ones through other means. From an income tax standpoint, though, it's not always advisable to name a charity as your Roth IRA beneficiary. Because a qualified charity is a tax-exempt entity, the benefit of income tax-free Roth IRA distributions is wasted on the charity. It may make more sense to benefit a loved one with the income tax-free Roth IRA distributions, and leave a traditional IRA or other taxable assets to your favorite charity. The beneficiaries of a traditional IRA usually have to pay income tax on their distributions. Because a qualified charity is tax exempt, though, the charity would receive the distributions tax free.

With charities, the five-year rule is used for taking post-death distributions (i.e., all distributions will be taken on or before the end of the year during which the fifth anniversary of the account owner's death occurs).
Your estate
If you name your estate as the beneficiary of your Roth IRA, the money in the account first goes to your estate, and then what's left passes to your heirs according to the terms of your will (if you have one) or through the laws of intestacy. Naming your estate as beneficiary is usually not advisable. First of all, you sacrifice some planning options. Second, the Roth IRA will have to pass through the probate process instead of going directly to your loved ones; this can be costly and protracted, and can unnecessarily expose your Roth IRA to creditors. Finally, you may not be able to stretch distributions out over the lifetime of an individual beneficiary. Generally, the five-year rule will apply.

Why your choices matter
There are several factors you may want to consider when selecting beneficiaries for your Roth IRA. Although your primary concern may be to provide financial security for your loved ones, you should also take into account the ages and needs of your loved ones. In addition, you should keep the Roth IRA distribution rules in mind, as well as the beneficial income tax treatment that the Roth IRA may afford.

Because choosing a Roth IRA beneficiary is an important decision, you may want to select a beneficiary with the help of a tax advisor or other qualified professional. In addition, you should review your beneficiary choices periodically to ensure that they continue to be appropriate, since your financial and personal circumstances (and those of your beneficiaries) may change over time. Fortunately, you'll generally be free to add or remove beneficiaries whenever you want, though certain restrictions may apply.

Income tax considerations
As discussed, if the five-year holding period is satisfied, your beneficiaries will not have to pay income tax on your Roth IRA funds after you die. Moreover, funds left in a Roth IRA continue to accumulate free from income tax. So, the longer the funds remain there, the more your beneficiaries may benefit from tax-free growth. This is where your choice of beneficiary can play a critical role; your beneficiary designation may determine (in part) how long the funds can remain in the Roth IRA after your death.
Estate tax considerations
Your Roth IRA beneficiary choice may also impact your federal estate tax situation. Estate taxes may be a concern if you expect the value of your estate to exceed the applicable exclusion amount — $3.5 million for 2009 and $2 million for 2008. The full value of your Roth IRA will be included with your other assets to determine how much (if any) federal estate tax is due from your estate.

One potential estate-tax-saving strategy may be to name your spouse as the beneficiary of your Roth IRA and other assets. The federal marital deduction allows you to leave unlimited assets to your spouse free from estate tax.

Caution: By leaving all of your assets to your spouse, you may waste your applicable exclusion amount. You may defer estate taxes, but when your surviving spouse dies, his or her federal estate tax liability may be higher than necessary. Consult an estate planning attorney for more information.

To take full advantage of both the unlimited marital deduction and both spouses' applicable exclusion amounts, a better strategy may be to leave some of your assets in trust for your spouse and to leave some assets to other beneficiaries (such as children or grandchildren). Having a potentially income tax-free Roth IRA in a death tax saving trust may make more sense than having a taxable traditional IRA in the trust. Another possibility is to leave your Roth IRA and/or other assets to charity, allowing your estate to benefit from a charitable deduction.
Estate planning for retirement assets is complex. Consult an estate planning attorney about appropriate strategies to minimize estate taxes, and about how your Roth IRA should fit into your overall estate plan.

State law considerations
You must also consider how state law may affect your Roth IRA. Your spouse may have legal rights to your Roth IRA regardless of whether he or she is named as the primary beneficiary. In addition, if your roles are reversed (your spouse is the Roth IRA owner, and you are the primary beneficiary) and you die first, state law may prevent your surviving spouse from changing the beneficiary designation after your death regarding your interest in the assets — unless you grant your spouse the power to make these changes in a will or other document.

Caution: States may differ in their income tax and estate tax treatment of Roth IRA distributions. You should consult an estate planning attorney for details regarding these and other state-specific issues.