Traditional and Roth retirement accounts and estate planning
There are trade offs in deciding how to set the proportion to contribute into Roth versus traditional accounts. In many senses, this becomes an estate planning question. When an investor’s situation and lifetime financial model indicate that he or she falls into that relatively small percentage of the population that could benefit from holding some amount of Roth assets, then estate planning considerations can also be important to the decision. The analysis is not simply one of optimization within a single generation, because benefits can accrue to heirs who inherit Roth accounts directly and properly re-title them as inherited Roth IRAs.
For estate planning purposes, Roth accounts have some advantages over traditional tax-advantaged accounts. If a family’s financial model indicates that there is a good possibility that they will still have some tax-advantaged account assets at death, then those should be Roth tax-advantaged account assets, when feasible.
Designated beneficiaries can inherit both traditional tax-advantaged retirement accounts and Roth retirement accounts. Therefore, it is very important that the intended beneficiary designations are on file with the retirement account custodian and that these beneficiary designations be accurate. Review these designations periodically to ensure that the owner’s intent is current regarding beneficiaries. In particular, do this in a timely manner after any changes to the composition of the family that could prompt the need to alter the beneficiary designations. In general, retirement beneficiary statements supersede wills and trusts, so they are more important than some people may think.
Both inherited traditional tax-advantaged retirement accounts and traditional Roth retirement accounts can provide tax benefits to beneficiaries. However, the rules must be understood and followed to obtain these benefits. After inheritance, beneficiaries should understand these rules and seek professional legal advice, especially if the amounts involved are substantial.
Traditional and Roth IRA accounts and SECURE Act estate planning considerations after the SECURE Act of 2019
While I will not attempt to summarize inheritance rules for tax-advantaged retirement accounts here, you should note the following about inherited traditional and Roth retirement accounts. Traditional and Roth account assets can be inherited by children and other designated family beneficiaries. Prior to the passage of the US SECURE Act which was signed into law in December of 2019 and took affect at the beginning of 2020, inherited Roth assets can grow tax-free over the expected life of the person inheriting with certain mandatory withdrawal requirements. This was sometimes known as the “stretch IRA,” but the stretch IRA is now history.
With the passage of the SECURE Act this lifetime advantage has been significantly reduced for non-spouse beneficiaries who inherit traditional or Roth retirement accounts. Now, both inherited traditional IRA retirement accounts and inherited Roth IRA retirement accounts must be distributed to a non-spouse beneficiary within a 10 year period. Required minimum distributions are no longer for inherited IRA retirement accounts. Instead, the requirement is that all assets be removed from an inherited IRA account within a 10-year period.
Note that this 10-year distribution period does not apply to spouses who inherit retirement accounts. They still benefit from distributions over their expected lifetime and are subject to RMDs. The age of initial RMDs was also increased by the SECURE Act from age 70 and 1/2 up to age 72.
Investment strategy and taxation affect ten-year SECURE Act distributions from inherited traditional and Roth accounts
Management of an inherited Roth IRA account would seem to be more straightforward under the terms of the SECURE Act, since Roth assets would not incur taxation upon distribution. Thus, it would be advantageous to keep the assets in the inherited Roth IRA throughout the ten years to allow for continued potential tax-free appreciation. Near the end of the ten year period, inherited Roth IRA assets would then need to be distributed for subsequent holding within a taxable asset account.
Inherited traditional IRA account assets would require more thought as to how they should be managed. Inherited traditional IRA assets would also need to be distributed to the beneficiary within a ten-year period. Should those assets be distributed and taxed near the beginning of the ten-year period, across the ten-year period, or near the end of the ten years? The answer, of course, will depend upon the beneficiary’s potentially shifting income tax situation of the ten years. Because the amounts distributed would be subject to ordinary income taxes, many people may benefit from a series of distributions over multiple years compared to a larger lump sum distribution that might push the beneficiary into a significantly higher tax bracket for a particular year. Obviously, if low income years are anticipated, distributions during those years would incur lower taxes.
One’s investment portfolio management strategy would also come into play in this distribution decision. Would the inheriting beneficiary prefer to take more assets out of the account earlier in the 10 year period to avoid paying more income taxes on greater appreciation within the inherited traditional IRA account?
If an investor implements asset tax location optimization across their portfolio and across time, that investor might be inclined to remove assets earlier during the ten-year period. While they would pay ordinary income taxes sooner, doing this would allow them to re-position those assets in taxable accounts and invest them in equities which could be subject to lower federal long term capital gains taxes versus paying ordinary income taxes in the future. If the inherited assets are substantial, it might make sense to run some scenarios with the VeriPlan financial planning spreadsheet software understand the value of various alternative decisions.
