Roth IRAs can be an excellent way to save and invest for your retirement. In exchange for paying tax on your income now, you can allow your money to grow for decades and then withdraw it tax-free. In addition to the well-known tax benefits, Roth IRAs can be smart financial tools for another reason: estate planning.
Roth IRAs: The quick version
Roth IRAs are tax-advantaged retirement savings vehicles, to which contributions are made on an after-tax basis. In other words, you don't get a tax deduction now, but your qualified withdrawals from a Roth IRA will be 100% tax-free. And in the meantime, your investments grow tax-free, with no dividend or capital gains taxes eating away at your returns.
This effectively allows you to "lock in" your current marginal tax rate. This makes Roth IRAs especially smart tools for younger individuals, whose marginal tax brackets are quite low early in their careers. Plus, there's no telling what the U.S. tax brackets will be when you retire. The top tax bracket was 70% not too long ago, and it's entirely possible that by the time you retire, your tax rate could be significantly higher than it is now.
In addition to the tax advantages, there are several perks to Roth IRAs over other types of retirement accounts. To name one big benefit, you are free to withdraw your original contributions (but not your investment gains) at any time, for any reason, without penalty, which makes a Roth IRA an excellent choice for people who are concerned about having their money "tied up" for decades.
Perhaps the best benefit of Roth IRAs
In addition to the benefits I've already mentioned, perhaps the best benefit of investing in a Roth IRA is that you are free to leave your money in the account for as long as you want, and can continue to contribute to your account for as long as you're earning income.
This is in direct contrast to traditional IRAs and most other retirement accounts, which require the account owner to begin taking minimum distributions after reaching 70 1/2 years of age, regardless of whether they need the money or not. In the eyes of the IRS, you've already paid your taxes on contributions to your Roth IRA and the agency cannot tax one penny of qualified Roth distributions, so they don't really care when you want to withdraw your money.
Because of this, Roth IRAs have incredible compounding power, especially if you don't need to use the money. Think of it this way – let's say that by the time you reach 70 years old, you've built up a $500,000 balance in your Roth IRA. Assuming 7% average annual returns, if you live until age 85, your account could grow to $1,380,000 that you could leave to your heirs. If you live until 90, you could leave them $1,935,000 -- tax-free.
What it means to your heirs
The rules governing an inherited Roth IRA depends on who is inheriting the account – specifically, if it's your spouse or not.
If your spouse inherits your Roth IRA, the rules are easy. They can simply treat the inherited Roth IRA as if it were their own, either by becoming the account holder or rolling the account into an IRA they already own.
If someone other than your spouse inherits your Roth IRA, or if your spouse chooses to be treated as a beneficiary (and not become the account owner), the rules are a bit different. The beneficiary then has a couple options. Specifically, they can choose to:
- Take a lump-sum distribution from the Roth IRA. Roth IRA earnings can be taxable if the account is less than five years old at the time of the owner's death. And even if the beneficiary is under 59 1/2, there is no early withdrawal penalty with an inherited IRA.
- Take required minimum distributions from the account. These can either be taken within the first five calendar years following the account owner's death, or spread over the beneficiary's life expectancy, starting no later than Dec. 31 of the year the account holder dies. As long as the aforementioned five-year rule is satisfied, there will be no tax liability.
The Foolish bottom line
If one of your goals is to leave money to your heirs, a Roth IRA can allow you to grow your money tax-free for as long as you'd like, and your heirs can then draw tax-free income from the account for years. Be sure to take this into consideration if you don't anticipate needed all of your retirement savings to cover living expenses.
The Motley Fool has a disclosure policy.