Inherited ROTH IRA

[bmpasternack]

For tax purposes what are the advantages and disadvantages of naming a Revocable Living Trust as beneficiary of a ROTH IRA vs naming the Trust's Settlor?  What happens if the Settlor has died before the ROTH is distributed; does the Trust still exist after Settlor's death or does the ROTH go to the backup benficiaries?

[NCperson]

@bmpasternack why are you contemplating this?

The Roth IRA  upon distribution is already tax free.

What 'tax purposes' are you comtemplating that causes the question.  

[dmertz]

I think you mean trust beneficiary, not the trust settlor.   The trust settlor would be the owner of the IRA, so the trust settlor can't be a beneficiary of the IRA (nor can the trust settlor be a beneficiary of the trust since the trust settlor will be dead).

What would be the purpose of adding the complication of making the trust the beneficiary unless the trust provides restrictions on the distributions from the trust to trust beneficiaries or is intended to specify successor beneficiaries?  The beneficiary designation for the IRA can include multiple primary beneficiaries and can include multiple contingent beneficiaries that would apply if all of the primary beneficiaries predecease the IRA owner.  Some IRA custodians also allow even more complicated custom beneficiary designations.

Making a trust the beneficiary rather than making individuals the beneficiaries adds requirements for the trust to be able to look through to determine RMDs for the Roth IRA rather than being subject to the 5-year rule and if there are multiple beneficiaries the separate accounts rule would not apply for determining RMDs.  If the beneficiary would be the IRA owner's spouse, making the trust the beneficiary would also add substantial complications in the surviving spouse to be able to treat the Roth IRA as the surviving spouse's own.

[bmpasternack]

Perhaps my original statement of the question was unclear.  So let me restate the situation I am trying to address.

Person A has a Roth and they are trying to determine the best way to name beneficiaries in order to minimize any taxes and keep the record keeping simple.  So A could name Person B as primary benficiary and Person C, a child of B, as backup or the primary could be Person B's Revocable Living Trust, which specifies furure dsitributions of assets to C.  If B dies before A, upon A's death would the Roth be inherited by the Trust if the Trust was named as primary beneficiary of A's Roth or would it go to C, the backup beneficiary.  The reason for considering this approach is to ensure that C does not get a windfall inheritance at the time of A's death as opposed to getting payouts from the Trust over time.

[NCperson]

@bmpasternack this is not a tax issue.  It's an estate structuring issue. 

How much money are we talking about? is this a grandparent - parent - young adult situation? 

First, the record keeping and cost to maintain is not simple or cheap.  (i've personally looked into this)

a) Lawyers are required to set this all up (figure easily $2000 - $5000) 

b) Who is going to be the Trustee? Is that going to be a 3rd party firm?  if you anticipate this trust outliving A and B, who is going to manage this whole thing if not a third party (e.g. a trust firm) that charges for its services. Figure around 75 b.p. of the asset value (annually) to hire  a trustee firm (assuming these are financial assets). 

While you recognize the Trust will distribute to C over time, are you aware of the agressive nature of the tax rates for Trusts? At $13,000 of income, the tax bracket is 37%, so the Trustee is motivated to distribute an amount of money that exceeds the income of the Trust each year.  The beneficiary pays the tax at his tax rate. 

Another issue is whether the Roth distribution is a 5 year or 10 year requirement.  My understanding is if the beneficiary of the Roth is a named person, it's 10 years, even if the owner is a Trust.  But you introduced the notion that a Trust could be a beneficiary and I suspect (not sure) that suggests a 5 year payout requirement. 

Controlling money from the grave is far from a free lunch!  Suggest employing an estate lawyer - this is quite complex to discuss on an anonymous tax community board. 

ps does this mean you read "Beyond the Grave"? 

https://www.amazon.com/Beyond-Grave-Revised-Updated-Children/dp/0062336223

[Opus 17]

If a person inherits a Roth IRA, and the original owner was older than their beginning date, the beneficiary must withdraw all the money and close the account within 10 years, and must take RMDs each year until the account is distributed.  None of the proceeds are taxable.  If B dies before the inherited IRA is spent out, C inherits it as beneficiary under the same terms.

If a trust is the designated beneficiary, the distributions are still not taxable, but the account must be closed out in 5 years, and RMDs must be taken in the mean time.

What you are really asking is an estate planning issue.  For example, if B dies before C and C might be too young to manage their money.  You need more sophisticated and personalized estate planning advice.

[dmertz]

If the trust is the beneficiary of the Roth IRA, the 5-year rule would apply only if the trust was not qualified for look-through.  If the trust meets the requirements for being qualified for look-through (one of the requirements being that the IRA custodian is provided with a copy of the trust document by the end of the year following the year of death), RMDs are based the beneficiary of the trust (or if there are multiple beneficiaries, RMDs are based on the beneficiary with the shortest life expectancy; separate accounts treatment is not permitted with a trust being the beneficiary).

But I'll ask again, what purpose would you have for making the trust the primary beneficiary in the first place?  If you have no specific purpose for making a trust the beneficiary, it makes no sense to do so instead of making the beneficiary of the trust the beneficiary of the IRA directly.  Making the trust the beneficiary for no particular purpose only adds complexity and potential restrictions compared to naming the individual beneficiary directly.  If the trust beneficiary is allowed unrestricted access to the fund in the inherited Roth IRA, it would seem that the trust would be serving no purpose with respect to the Roth IRA.

Also, distributions from an inherited Roth IRA are not unconditionally nontaxable.  Distributions of earnings in the inherited Roth IRA are taxable if distributed before the end of the 5-year period beginning on January 1 of the year for which the decedent first made a Roth IRA contribution.  Earnings come out last.  Unless the beneficiary actually needs the funds to spend, it generally makes sense to leave the money in the inherited Roth IRA as long as possible to gain the most tax free earnings.  Unless the beneficiary was extremely old, it's unlikely that earnings would be required to be distributed before the Roth IRA completed the 5-year qualification period.

[NCperson]

@dmertz  he wants to control the money from the grave.  if his primary beneficiary passes prematurely, he want to ensure the contigent beneficiary doesn't inherit the entire corpus immediately. 

[dmertz]

@NCperson , thanks. I totally missed that.

If B is named directly, it would be up to B to name a successor beneficiary.  If B is the only primary beneficiary and predeceases A, then the beneficiary would be the contingent beneficiary which could be the trust.  If your intent is to also control who inherits if B dies after you or whether or not B could entirely drain the Roth IRA, you would have to make the trust the primary beneficiary and have the terms of the trust control the distributions from the trust to B and C.

As long as the Roth IRA is qualified by the time any earnings would have to be distributed, which is likely, the higher tax rates generally paid by trusts would not be a factor on distributions from the Roth IRA.  Any RMDs from the Roth IRA could be held in the trust and funds distributed from the trust according to the terms of the trust without any tax consequences other than those on any earnings on the assets outside the Roth IRA but still in the trust.  If the trust is the primary beneficiary, is qualified for look-through and neither B nor C predeceases A, I don't think that the IRS has yet provided guidance that clarifies how RMDs from the Roth IRA are determined in the case where either B or C is an Eligible Designated Beneficiary).  If neither B nor C is an EDB, the 10-year rule would apply as long as the trust was qualified for look-through.