A Roth IRA can be a great estate planning tool and can have the potential to give your heirs tax-free income during their lifetimes. If you are inheriting a Roth IRA from a friend or family member (other than your spouse) you currently have three options when it comes to taking out distributions from the Roth IRA: you can open an Inherited Roth IRA and take required minimum distributions over your life expectancy, you can take the entire amount out within 5 years, or you can take a lump sum distribution at the time you inherit the Roth IRA.
Since amounts can be withdrawn from an Inherited Roth IRA account tax free this offers those who inherit these types of IRA’s an opportunity to have a stream of tax-free income. Specifically, if only the required minimum distributions (RMD) are taken out each year, an inherited Roth IRA could potentially throw off many years or even decades of tax free distributions for a beneficiary. In the case where a Roth IRA is left to a grandchild, rather than the presumably older child, a Roth IRA can make over double the amount of lifetime tax free distributions. This is because funds are able to grow tax free and the distributions can be spread over a longer life expectancy.
For instance take a $250,000 Roth IRA that has been inherited by a 60 year old child versus a 25 year old grandchild. Assuming a 6% growth rate on the account, and that only the required minimum distribution is taken out annually, this would provide the child beneficiary approximately $586,000 worth of distributions over the next 25 years. Now, if the Roth IRA was instead left to a grandchild (and making the same assumptions listed above) the Inherited Roth IRA would provide the grandchild with approximately $2,179,000 worth of distributions over their lifetime.