"Be sure to read the fine print." It's neither complex, nor profound advice. Yet, it isn't easy advice to follow when you are navigating your way through pages and pages of IRS rules and regulations governing the way you manage your retirement savings plans. It quickly becomes clear that the IRS has not yet discovered the beauty of simplicity.
This is certainly the case with regard to the rules and regulations surrounding the Roth IRA. Although the average investor hasn't memorized IRS Publication 590, Individual Retirement Arrangements (IRAs), there are a few key rules you need to know about your Roth IRA that can help you avoid making some mistakes that could cost you or your beneficiaries down the road.
What is a Roth IRA?
The Roth IRA became available on January 1, 1998 as a result of the Taxpayer Relief Act of 1997. Unlike a traditional IRA, the Roth IRA offers no deduction for contributions (which are made with after-tax money). All of the tax benefits associated with a Roth IRA happen when withdrawals are made. Subject to certain rules and qualifications, withdrawals are not taxed at all. In other words, once you put your money in, you never pay taxes on that money again if you make qualified withdrawals. Other benefits of the Roth IRA include no early distribution penalty on certain withdrawals, and no minimum distribution requirements after age 70?, allowing your earnings to continue to grow tax-free.
An Estate Planning Tool
Because there is no required minimum distribution for the owner of a Roth IRA, it is possible to use the Roth IRA as an estate planning tool and pass on significant funds to your heirs. While your beneficiaries may have to pay estate taxes on the value of the Roth IRA, no part of the Roth IRA will be subject to income tax to your beneficiaries. Because Roth IRA earnings are not subject to income tax (to you or your heirs) much of the tax burden is eliminated.
That all sounds wonderful, but here's the caveat. The biggest problem with Roth IRA's is that many beneficiaries are not aware that they may be required to take distributions. Although the Roth IRA is not subject to required minimum distribution rules for the account owner it is important to point out that required minimum distribution rules apply for non-spouse beneficiaries of a Roth IRA. In fact, if the beneficiary of a Roth IRA waits too long before deciding how to handle the funds, he or she could wind up with a big tax bill down the road and an unforgettable lesson in frustration.
If a spouse is listed as the beneficiary of a Roth IRA, upon the owner's death, he or she keep the Roth IRA intact or elect to roll the Roth IRA over to his or her own Roth IRA. In either case, the spouse would not be required to take any distributions during his or her lifetime and would be allowed to designate new beneficiaries.
Unlike a spousal beneficiary, someone who is not the spouse of the Roth IRA owner is subject to different rules. That isn't necessarily a bad thing, but it is important to be aware of the differences. A non-spousal beneficiary must take full distribution either by the end of the year marking the fifth anniversary of the account holder's death or over the life expectancy of the beneficiary, starting no later than December 31 of the year following the year the account holder died. If distributions to the beneficiary do not start by December 31 of the year following the year of the owner's death, the rule requiring a complete distribution of the plan balance within five years will become effective & so it's important to plan accordingly. All qualified distributions would be tax-free. Failure to take the distribution results in a 50 percent penalty of what should have been distributed. Imagine paying a 50 percent tax when it could have been completely tax-free.
As a Roth IRA owner, the most important thing you can do is communicate with your beneficiaries and be sure they understand the rules and regulations governing Roth IRAs. The tax consequences involved with inheriting a Roth IRA can be complex and should be considered on an individual basis. Remember, a qualified financial planner can develop a financial plan that includes retirement planning and tax-savings strategies to help you best reach your long-term financial goals.
This information is provided for informational purposes only. The information is intended to be generic in nature and should not be applied or relied upon in any particular situation without the advice of your tax, legal and/or your financial advisor. The views expressed may not be suitable for every situation. Ameriprise Financial Services, Inc., Member NASD, part of Ameriprise Financial, Inc.