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Retirement Planning > Saving for Retirement > IRAs

How and Why to Use Roth IRAs in Estate Planning

By Roger Wohlner

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What You Need to Know

  • Roth IRAs can be a very effective estate planning tool for your clients.
  • A Roth IRA's benefits as part of estate planning should be reviewed yearly to determine if clients' circumstances have changed.
  • Roth IRAs also provide your clients with tax flexibility in terms of their own retirement withdrawals if needed. 

Roth IRAs and Roth IRA conversions have received a lot of press recently. Between the various tax proposals that have been floating around Congress and normal year-end tax planning strategies, Roth IRAs are a popular topic. 

Here are two main reasons to consider Roth IRAs as part of your client’s estate planning efforts. 

No RMDs

This may seem pretty basic to many readers, but one of the biggest estate planning benefits of a Roth IRA is the fact that there are no required minimum distributions. This is a powerful estate planning tool. The lack of RMDs allows the money in the Roth IRA to grow tax-free for the benefit of a surviving spouse or other beneficiaries. 

Besides the impact of RMDs reducing the amount of a traditional IRA, not having to take RMDs from a Roth IRA eliminates the taxes that would otherwise need to be paid on these distributions. These taxes can add up to a substantial amount over a period of years, reducing the size of your client’s estate.

The Secure Act and Inherited IRAs 

Since the rules governing inherited IRAs for most non-spousal beneficiaries under the Setting Every Community Up for Retirement Enhancement (Secure) Act went into effect at the beginning of 2020, Roth IRAs have become a very viable estate planning tool.

This is because beneficiaries who are not classified as eligible designated beneficiaries are required to withdraw the entire amount of their inherited IRA within 10 years of inheriting it. The Secure Act eliminated the ability to “stretch” inherited IRAs that was in place for IRAs inherited prior to Jan. 1, 2020, for most non-spousal beneficiaries. 

For inherited traditional IRAs, this results in the whole amount being taxed within 10 years of inheriting. The 10-year rule also applies to inherited Roth IRAs. But if the original account owner had met the five-year requirement prior to their death, then withdrawals from the inherited Roth IRA are tax-free. 

This makes Roth IRAs a beneficial estate planning tool as taxes that are bunched into a 10-year period can substantially erode the value of an inherited traditional IRA. 

Planning Considerations

For clients who already have Roth IRAs, they are set in terms of their spouse being able to inherit the account and use it as their own. For non-spousal beneficiaries, the main issue is the five-year rule. As with any type of IRA or retirement account, make sure their beneficiary designations are current and that they reflect your client’s desires. 

For clients with a Roth 401(k), it’s important that they roll this account over to a Roth IRA once they leave their employer to avoid RMDs. 

An additional consideration beyond the estate planning ramifications is the tax diversification a Roth IRA provides once your client is retired. Their changing circumstances might merit using some or all of their Roth IRA to take tax-free distributions in retirement at some point, and they now have the flexibility to do this. 

Roth Contributions

For clients eligible to do so, contributing to a Roth IRA each year can help build a Roth balance to pass on to beneficiaries. For those who have access to a Roth 401(k) account via an employer-sponsored plan or a solo 401(k) for the self-employed, contributing to a Roth 401(k) can offer a higher contribution limit with no income restrictions as with a Roth IRA. The amount in the Roth 401(k) can later be rolled over to a Roth IRA with no tax consequences, avoiding RMDs as well. 

Roth IRA Conversions 

A Roth IRA conversion is a strategy to consider for passing IRA assets to non-spousal beneficiaries either directly or as contingent beneficiaries upon the death of a surviving spouse. This is a viable way for a client to prepay taxes for their beneficiaries. 

Beyond prepaying the taxes, the five-year rule can come into play if your client did not previously have a Roth IRA. 

Whether or not a Roth IRA conversion makes sense as an estate planning tool depends on a number of variables, including: 

The client’s current tax situation. If they are in a high tax bracket, the amount due in taxes on the conversion may not be worth the ultimate tax benefits to the non-spousal beneficiaries. If the client is in a relatively low tax bracket, this can be more beneficial. This situation might be the case if your client has recently retired and is not yet taking their Social Security benefit.

Your client is relatively young. This might be someone in their 40s or 50s. This situation provides them with a potentially long time horizon for the converted amounts to appreciate in value and offset much of the impact of the taxes on the conversion.

In looking at the taxes that would be incurred by your client on the conversion, it is important to weigh this against the estimated tax savings in the future from not having to pay taxes on the RMDs for the amounts converted. 

Whether or not a Roth IRA conversion is both beneficial and desirable as an estate planning strategy can vary from year to year based on your client’s tax situation and that of the overall family. 

Backdoor and Mega Backdoor Roths

These two strategies have been in, out and in again (at least currently) as part of the Democrats’ tax and spending bill. The latest version of this proposed legislation has included the provisions that would eliminate the conversion of after-tax amounts in an IRA or retirement plan such as a 401(k) by the end of 2021. At this point it is hard to be sure what the final version of the bill will look like with regard to these strategies. 

If your client has a mega backdoor Roth via their employer’s 401(k), you should at the very least look at the options for this money if this is prohibited in the final bill. If a backdoor Roth makes sense for a client, you will want to be sure to get this done prior to Dec. 31 of this year. 

Roth IRAs have many potential benefits as a planning tool for your clients. With the advent of the Secure Act and the evolving tax and estate landscape, a Roth IRA can play a key role in your client’s estate planning efforts under the right circumstances.

Roger Wohlner

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