If you have a Roth IRA, and you’re unlikely to need to tap into the account for retirement income, your IRA can serve as a vehicle for leaving an inheritance to your loved ones. Here’s how it works:
Contributions to a Roth IRA are made with after-tax dollars. Since you’ve already paid income tax on the money going into the account, the IRS allows that money to grow, tax-free – if you chose to withdraw money from your Roth during your retirement, you’d owe no income tax, even on the interest earned by your account over the years. Why is this significant? Since the IRS doesn’t tax Roth IRA distributions, there’s no need for the Required Minimum Distributions (RMD’S) that accompany other types of retirement plans. So, if you don’t need the cash, you can leave it in your IRA to continue growing until your death.
As with other retirement plans, you have the opportunity to designate one or more beneficiaries to inherit your account when you pass away. This transfer is relatively simple and, as long as you name a beneficiary who’s living at the time of your death, the transfer happens outside the probate process.
RMD’s for Beneficiaries
Once a beneficiary inherits your account, the tax rules change a little. The person inheriting the account pays income tax on distributions, and the IRS imposes Required Minimum Distribution rules on Roth IRA inheritors. A Required Minimum Distribution is the bare minimum that your beneficiary must withdraw from the account each year (or face penalties). The amount of each RMD is determined by two factors: your beneficiary’s remaining life expectancy and the balance remaining in your IRA. If you have more than one beneficiary, then the RMD is calculated based on the oldest beneficiary’s life expectancy.
The way for your beneficiary to get the most possible benefit from an inherited Roth IRA is to withdraw only the RMD each year. This allows the largest possible amount of money to remain in the account and continue to grow, and it’s called “stretching” the IRA.
Your estate planning attorney can offer strategies for ensuring that your beneficiary gets the most from an inherited Roth IRA.