Slott Report Mailbag: What is the Best Way to Leave My Roth IRA to Grandchildren?

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

You want to leave your Roth IRA to your grandchildren. You are worried about required distributions at age 70 ½ if you are still working. You want to know all of the tax specifics of a year-end Roth conversion. You have come to the right place, a special post-holiday Monday edition of The Slott Report Mailbag.  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1. I have converted some of my IRA to a Roth IRA, which I want to leave to my grandchildren who are minors. What is the best way to do this?

Answer:
Minors should not be named directly on the beneficiary form. They cannot sign the necessary paperwork to establish the inherited IRA, they cannot manage the investments, and they cannot request the required distributions (RMDs) each year. An intermediary needs to be named to act for the minors. The type of intermediary will depend on the size of the inheritance for the children. For a sizable account, generally the best thing to do is to set up a trust for the minors and name the trust as the beneficiary of the IRA. All the beneficiaries of the trust will have to use the age of the oldest trust beneficiary for calculating RMDs. In the trust you can stipulate the age the beneficiaries must attain in order to have access to the inherited Roth IRA funds.

For smaller accounts, you might be able to name a guardian for the minor either in your will or on the beneficiary form. You should check with the IRA custodian to see if either option is allowed without the necessity of a court appointment. Another option would be to name an UGMA (Uniform Gifts to Minors) trust as the beneficiary. In either of these scenarios, the grandchild would have access to the inherited account when he/she reaches the age of majority – either 18 or 21.

2. I will be 70 ½ this year and am still working and contributing to my 401(k). What required distributions will I have to take this year?

Answer:
You will have to take required distributions (RMDs) from any IRAs (including SEPs and SIMPLEs even if you were still working for the company that sponsors the plan) that you have and from any plans of employers for which you no longer work. There is an exception to the RMD rules for employer plans such as 401(k)s and 403(b)s if you are still working for that employer. If you are not a 5% or more owner of the company and if the plan allows, you can delay taking RMDs until you separate from service. Once you separate from service, you have a required distribution for the year of separation. You can defer taking that distribution until April 1 of the following year but you would then have to take the RMD for that year also by the end of the year. So you would end up having to take two distributions in one year. If you want to roll your employer plan funds over to an IRA, you will have to take any undistributed RMDs before you can roll the balance of the plan funds to an IRA.

3. I am ready to do a Roth conversion. When I go through with it, what part is taxable?

Answer:
If you have both pre- and after-tax amounts in your IRA and are doing a partial conversion, the pro-rata tax rule will apply. The formula is on IRS Form 8606. Basically, you take all the after-tax funds in all your IRAs and divide that amount by the year-end account balance in all your IRAs. The percentage is the percent of the amount converted that will not be taxable. You must include SEP and SIMPLE IRAs in these balances.

If you are converting assets in kind, i.e. the assets themselves are moving to the Roth IRA account, the value used will be their fair market value as of the date they are transferred to the Roth IRA. For most stocks, bonds and mutual funds this will be easy to determine. For non-publicly traded assets, you will need to have an appraisal done. If you are converting annuities to a Roth IRA that have riders for guaranteed benefits, the current fair market value of those riders must be calculated by the insurance company as part of the valuation of the asset on the date of conversion.