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Roth IRA beneficiaries: It’s a matter of trust

by on
in Leaders & Managers,Management Training

This may be the year you finally convert your traditional IRA to a Roth. But who should you name as the beneficiaries? Usually, it’s the kids or grandkids.

Strategy: Designate a trust as beneficiary instead. This way, you don’t have to worry about teenagers squandering the funds from an inheritance. The youngsters can gain full access to the funds at a specified age.

A trust arrangement is particularly beneficial for a Roth IRA because you can stretch out payments even longer than you can with a traditional IRA.

This is because there’s no requirement to begin taking annual distributions after reaching age 70½. So, if you don’t need the money, you can keep the Roth IRA nest egg intact for your heirs.

Here’s a quick recap: Unlike a traditional IRA, “qualified distributions” from a Roth—for example, distributions made after age 59½—in existence five years are completely tax-free. That creates an incentive to convert a traditional IRA to a Roth. However, prior to 2010, a Roth conversion wasn’t permitted in a year in which your modified adjusted gross income (MAGI) exceeded $100,000.

Now the $100,000 cap has been removed. What’s more, if you convert to a Roth in 2010, the taxable income from the conversion can be split evenly over the following two years—2011 and 2012.

The Roth IRA/trust combo might enable you to stretch out payments for several decades.

Example: Let’s say your Roth is valued at $300,000 after the conversion. You want to leave the Roth account balance to your three grandchildren with one-third going to each. So you set up a trust that takes effect at your death.

After your death, the Roth IRA lives on, but it must make minimum annual payouts. Because you’ve set up a trust as the beneficiary, the payments go from the Roth to the trust.

The minimum payout is based on the life expectancy of the oldest heir at the time of death. For instance, if the oldest grandchild is age 12, the remaining life expectancy is approximately 70 years. Therefore, the Roth must pay out about 1/69th of the funds in the first year, 1/68th in the second year and so on. There’s no limit on withdrawals, so the trustees may withdraw bigger amounts if needed.

The distributions from the Roth to the trust are tax-free (assuming the five-year rule is met by the time any distributions occur). Thus, your heirs can continue to benefit from tax-free compounding over an extended period of time. Of course, you might decide to leave the Roth to your adult children, not your grandchildren. However, the younger the age of the beneficiary, the longer you can extend the tax shelter.

Be careful when leaving a Roth trust to multiple heirs of varying ages. Reason: The payout period is based on the age of the oldest heir. If the age disparity is great, you might split the Roth IRA and create two trusts, one for the youngest heirs and one for the older heirs. In essence, you can set up as many separate accounts as you want.

Note that the trusts must last as long as the Roth IRA. However, in most states you can give heirs control over the money when they reach the age of majority.

This is not a do-it-yourself proposition. Use an attorney to set up the trust. Depending on your situation, it may cost you anywhere from several hundred to a few thousand dollars.

Tip: Leaving a Roth to grandchildren may trigger the generation-skipping tax. But your estate can benefit from an exemption (currently scheduled to be $1 million in 2011, but hopefully more if Congress takes action).

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