Inheriting a Roth IRA

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If you inherit a Roth IRA, you are called a beneficiary. A beneficiary can be any person or entity the owner chooses to receive the benefits of the IRA after he or she dies. Careful selection of beneficiaries, timely and proper titling of inherited accounts, and awareness of distribution options can maximize the value of an inherited Roth IRA. In almost all cases, it is advantageous to name the primary and contingent beneficiaries you wish to inherit your Roth IRA.

Except for a few situations, inherited Roth IRAs are subject to most of the same rules as inheriting a traditional IRA. The main differences for an inherited Roth IRA are:[footnotes 1][1]

  1. The deceased owner is always treated as passing before their Required Beginning Date, because there is no Required Beginning Date for an owned Roth IRA.[footnotes 2]
  2. Taxation rules follow those of owned Roth IRAs in that the 5 year holding period for qualification runs while the owner is alive and continues after his death. The beneficiary therefore needs to know the first year the owner made a Roth contribution.

Multiple non-spouse beneficiaries can create separate inherited Roth accounts by the end of the year following the year of death just as for non-Roth inherited IRAs. This will enable them to each use their own life expectancies for RMDs (Required Minimum Distributions), since RMDs are required for Roth beneficiaries, but not for owners.[1]

Spousal beneficiaries

Spousal Inheritance of an IRA

You will only be considered to have chosen to treat the IRA as your own if:

  • You are the sole beneficiary of the IRA, and
  • You have an unlimited right to withdraw amounts from it. [2]

You will be considered to have chosen to treat the IRA as your own if:

  • Contributions (including rollover contributions) are made to the inherited IRA, or
  • You do not take the required minimum distribution for a year as a beneficiary of the IRA. [3]

If you inherit a Roth IRA from your spouse, you generally have the following three choices. You can:

  1. Treat it as your own IRA by designating yourself as the account owner.
  2. Treat it as your own by rolling it over into your Roth IRA.
  3. Treat yourself as the beneficiary rather than treating the IRA as your own. [4]

Treat as your own (spousal rollover)

There are a number of clear advantages to spousal rollovers of a Roth IRA.

  1. By using a spousal Roth rollover, the surviving spouse can avoid any requirements to withdraw funds from the account. However, one needs to keep in mind that withdrawals of conversions within 5 years and before 59.5 will be subject to the 10% penalty on the taxable portion, and withdrawals of earnings will be subject to both tax and the 10% penalty.[1]
  2. A spousal rollover allows a surviving spouse to name primary and contingent beneficiaries to the IRA. This allows the surviving spouse, if the situation warrants, to correct any problems in the original beneficiary designations. Naming beneficiaries for the spousal IRA can provide these beneficiaries with the option of using their own life expectancies for drawing down minimum distributions from the IRA once they inherit it.

If a sole spouse beneficiary opts to maintain the Roth as an inherited Roth, no RMDs are required until the year the deceased spouse would have reached 70.5. Once that year arrives, if the surviving spouse passes, the named successor beneficiaries will have to continue the RMD schedule of that surviving spouse and will not be able to use their own life expectancies.[1]

A spouse, however, might decide to forgo a spousal rollover if he/she is under the age of 59 and 1/2 and has a clear need for the income from the Roth IRA. As beneficiary, the surviving spouse is required to take minimum distributions from the account. Withdrawals of earnings would be exempt from the 10% early withdrawal penalty tax. [5]

As a spousal beneficiary

A sole spousal beneficiary will inherit a fully qualified Roth if the owner first contributed at least 5 years before death. The death of the owner replaces the age 59.5 requirement for the Roth to be qualified.[1]

If the spousal beneficiary already owned their own Roth IRA, rolling the inherited one over will enable the 5 year period to be based on the older of the inherited Roth or their own Roth. The sole spousal beneficiary does not need to start RMDs as a beneficiary until the year the deceased spouse would have reached 70.5, should they not roll it over to their own Roth IRA.[1]

Circumstances warranting a spousal beneficiary continuing the inherited Roth status are limited to cases where the Roth has earnings but the surviving spouse is not yet 59.5, and the surviving spouse needs to take a lump sum distribution. In this situation, taking it from the inherited Roth would avoid the 10% penalty on the taxable earnings, while assuming ownership would not.[1]

Non-spousal beneficiaries

Whereas a Roth IRA account owner is, under current regulations, not required to take distributions from a Roth IRA, a non-spousal beneficiary of a Roth IRA is required to make distributions from the account. There are two options for deferred distribution (a beneficiary can always take a lump sum distribution or withdraw more than the required minimum distribution, although doing so eliminates the tax-free compounding of investment returns):

  • Rule 1: The Five Year Rule- Receive the entire distribution by December 31 of the fifth year following the year of the owner's death.
  • Rule 2: Lifetime Withdrawals- Receive the entire distribution over your life, or over a period not extending beyond your life.[6] These distributions are required minimum distributions (RMD) taken from the IRS Single Life Expectancy (Table 1). [7] The table provides a divisor factor, based on the beneficiary's age. The beneficiary divides this factor into the year end value of the Roth IRA to determine the required minimum distribution. The divisor factor is reduced by 1 for each succeeding year.
Example

Mary Page, age 48, has inherited a Roth IRA from her mother, Frances. She has opted to take lifetime distributions from the IRA. The account balance of the inherited Roth IRA , at the end of the prior year was $100,000. The divisor factor for age 48 from the IRS Single Life Expectancy Table 1 is 36. Mary divides the account balance by the factor. The resulting $2,778 is her required minimum distribution for the year. Next year Mary will reduce the divisor factor to 35, and divide this into the year end account balance to determine the RMD for the year.

If you inherit a Roth IRA from anyone other than your deceased spouse, you cannot treat the inherited IRA as your own. This means that the following actions are not permitted:

  1. You cannot make any contributions to the inherited Roth IRA.
  2. You cannot roll over any amounts into or out of the inherited Roth IRA into your own Roth IRA.
  3. Should you inherit Roth IRA's from more than one individual, the inherited Roth IRAs cannot be commingled or aggregated. Transfers between IRAs and RMD calculations must be made within each group of inherited IRAs. [8]

However, you can make a trustee-to-trustee transfer to an inherited Roth IRA as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary. [9] .

Example

"Harvey Schmidt (deceased April 10, 2008) Roth IRA, For the Benefit of Thomas Schmidt (beneficiary). SSN xxx-xx-xxxx."

Multiple beneficiaries of a Roth IRA should split the IRA into separate interests so that each beneficiary can:

  1. Select a fiduciary of choice for investing the inherited IRA;
  2. Possess the capability of executing their own individual investment plan and account succession;
  3. Have the option of taking required minimum distributions from the IRA over their individual life expectancy. [10] If an IRA having multiple beneficiaries is not split into separate accounts, the required minimum distribution is based on the life expectancy factor for the oldest beneficiary. [11]

If you are taking RMD based on the life-expectancy method, distributions must begin by December 31 of the year following the original account owner's year of death. If you are one of multiple beneficiaries, all beneficiaries must have established separate inherited IRA accounts by this date in order to calculate distributions based upon each beneficiary's own life expectancy.

If you establish multiple inherited Roth IRA accounts (for example, multiple mutual funds) you can make tax-free transfers between the inherited IRA accounts. Although the RMD must be figured on each individual inherited IRA (mutual fund), the RMD can be taken from any of the IRAs. [12]

Example

Jill Scott has inherited a Roth IRA from her father, Thomas Scott, who held his Roth at Merrill Lynch. Jill has executed a trustee-to-trustee transfer of the inherited IRA to Vanguard and has invested the IRA in three Vanguard Funds:

  • Vanguard Total Stock Market Index
  • Vanguard Total International Index
  • Vanguard Short Term Treasury Fund

She can transfer funds tax-free between each of these funds (and any other funds she opens within this inherited IRA). Each year she must figure her required minimum distribution for each of the three funds. She can take the distribution from any of the three funds.

An inheritor of a Roth IRA can, and should, name primary and contingent beneficiaries to the inherited IRA. The inherited IRA will always retain the required minimum distribution schedule for the original inheritor. [13]

Example

Mary Page, who has inherited a Roth IRA at age 48 from her mother, Frances, named her children, Ronald and Susan as successor beneficiaries of the inherited IRA. Mary dies at age 63. At age 63, Mary has a divisor of 21 (the original divisor 36 when she inherited the account minus the 15 years she has held the account). Mary will have a distribution made for her year of death. Ronald and Susan will then be able to distribute their inherited accounts over the remaining 21 years of Mary's original term, reducing the factor by 1 for each succeeding year. Ronald and Susan should also name successor beneficiaries for their respective inherited IRAs.

Estate as beneficiary or beneficiary not named

Not naming a beneficiary or naming the estate as beneficiary of a Roth will subject the estate to the 5 year rule above regardless of the age of the owner at death. For a traditional IRA, this is only true if the owner passed prior to the Required Beginning Date.[1]

If one does not name beneficiaries to the Roth IRA, the Roth IRA will be inherited by the decedent's estate and will be distributed to the beneficiaries established by will or intestacy law. An estate executor can still designate an inherited Roth IRA to the beneficiaries, as long as this is completed by December 31 of the year following the decedent's death.

Here is a sample letter which estate executors can use to properly execute the transfer of the inherited Roth IRA to beneficiaries: Fiduciary Letter Transferring Plan Account to Beneficiary

If the estate remains the Roth IRA beneficiary, the IRA must be distributed according to the five-year rule. Under the five-year rule, the assets must be distributed by December 31 of the fifth year since the retirement account owner's death. [14]

Advanced beneficiary options

These beneficiary options require the services of a qualified estate planner.

  • Naming a revocable or testamentary trust as Roth IRA beneficiary.
  • Disclaiming a Roth IRA

Tax factors

While most distributions from an inherited Roth IRA will be tax free distributions, there are circumstances in which a tax may be assessed.

An inherited IRA by regulation is not subject to the 10 percent early withdrawal penalty tax (excepting Spousal rollovers, discussed later).

However, it is possible for the earnings of an inherited Roth IRA to be subject to tax if withdrawn. This is due to the five year holding requirement for inherited Roth IRAs. In order for earnings to be qualified for tax free distribution, the original account owner must have held the Roth IRA for a minimum of five years. The account can be started by either contributions or conversions. [15] If a Roth IRA is established by a conversion that is subsequently recharacterized the original Roth establishment date is nullified and will be established if and when the recharacterized funds are reinvested into the Roth IRA. [16] The five year threshold is met on January 1 of the anniversary year. The following table provides the five year anniversary threshold for various creation dates.

Roth IRA Five Year Holding Period Requirement
First Year Roth Contribution Five Year Date
Prior to 2007 Passed requirement
2008 January 1, 2013
2009 January 1, 2014
2010 January 1, 2015
2011 January 1, 2016
2012 January 1, 2017
2013 January 1, 2018

The ordering rules for Roth IRA distribution provide options for avoiding this tax on earnings.

Example

Amanda Parker inherits a Roth IRA from her uncle Charles. The IRA was started in 2007 and has a value of $6500 consisting of $6000 of contributions and $500 of earnings. If Amanda takes immediate distribution of the account she will receive the $6000 of contributions tax free. The $500 of earnings will not be subject to the 10% early withdrawal penalty, but because the Roth IRA fails the five year test, Amanda will have to report the $500 of Roth earnings as a taxable distribution on her tax return. Amanda can escape taxation in this instance by only withdrawing the $6000 of contributions and retaining the $500 earnings in an inherited Roth IRA. She can use the Five Year Rule to delay distribution until the five year holding period is reached. The distribution will then be tax free.

For larger accounts with insufficient tenure (most likely converted accounts) the ordering rules usually mean that RMD distributions will be made from contributions/and or conversions and will not distribute earnings until well after the Roth IRA passes the five year test.

If in any year the distributions from an inherited Roth IRA are less than the required minimum distribution for the year, you may have to pay the Tax on excess accumulations (insufficient distributions), a 50% excise tax for that year on the amount not distributed as required. The tax on excess accumulations is reported on IRS Form 5329. [17] [18]

Finally, for large estates, a Roth IRA may be subject to the estate tax.

Roth 401k and Roth 403b accounts

Beginning in 2006, corporate qualified plans, such as 401k and 403b plans, were empowered to offer a designated Roth account (DRAC) within the plan. The distribution rules governing these plans are somewhat different from those governing individual Roth IRAs. Among the differences:

  1. Roth 401k and Roth 403b accounts are, unlike individual Roth IRAs, subject to the required minimum distribution rules governing qualified retirement plans. This means that RMDs would commence at age 70 1/2 for retired planholders. This RMD requirement can be avoided by executing a rollover (trustee-to-trustee) of the corporate plan Roth over to an individual Roth IRA. [19]
  2. The five year holding period for 401k and 403b Roth IRAs (DRACs) is applied for each particular plan held by the employee.
  3. Ordering rules for Roth IRA distributions do not apply to DRACs. Any distribution from the account is prorated according to the proportion of account basis and earnings in the account. [20]
  4. The five year holding period for DRACs does not carryover to a Roth IRA rollover. A rollover to a first time Roth IRA begins the holding period for the rollover. A rollover into an existing Roth IRA will receive the tenure of the existing IRA. [21]

Qualified distributions

Once an inherited Roth is qualified (5 years from original contribution), it is fully qualified and Form 8606 is not required to report distributions. The gross distributions are entered only on line 15a of Form 1040. For non-qualified inherited Roth IRAs, the basis from regular contributions and conversions is prorated according to each beneficiary's percent interest.[1]

Notes

  1. See: IRS Publication 590, [Distributions After Owner's Death or (PDF)
  2. April 1 of the year following the year in which you reach age 70½ is referred to as the Required Beginning Date. (Ref: IRS Pub 590)

References

  1. 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 Comments in wiki Discussion tab (Inheriting a Roth IRA) by forum member Alan S.
  2. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 169. ISBN 0-9649440-7-3
  3. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 170. ISBN 0-9649440-7-3
  4. IRS Pub. 590. p.20.
  5. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 164-165. ISBN 0-9649440-7-3
  6. Inherited Roth IRA, Fairmark Tax Guide
  7. Single Life Expectancy (Table 1)
  8. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 90. ISBN 0-9649440-7-3
  9. IRS Pub. 590. p.20.
  10. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 91-95. ISBN 0-9649440-7-3
  11. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 90. ISBN 0-9649440-7-3
  12. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 73. ISBN 0-9649440-7-3
  13. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p 75. ISBN 0-9649440-7-3
  14. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 89-90. ISBN 0-9649440-7-3
  15. Inherited Roth IRA, Fairmark Tax Guide
  16. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 233. ISBN 0-9649440-7-3
  17. Form 5329
  18. IRS Publication 590
  19. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 261. ISBN 0-9649440-7-3
  20. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, p. 261. ISBN 0-9649440-7-3
  21. Natalie Choate, Life and Death Planning for Retirement Benefits, 6th Edition, pp. 267-269. ISBN 0-9649440-7-3

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