Because of their tax-free status and lack of required minimum distributions (RMDs) during the original owner’s lifetime, Roth IRAs are attractive accounts for investors to bequeath to their descendants.
If you are at least 591/2 years old and have had a Roth IRA account for at least five years, you can make Roth contributions with after-tax money and enjoy tax-free payouts.
After they inherit the account, your beneficiaries can continue to benefit from the tax-free status for a period of time. However, unless the Roth account is passed down correctly, they will not be able to realize their tax savings. Here’s everything you need to know about it.
Do ROTH IRAs pass to beneficiaries tax-free?
Contributions to a Roth IRA can be withdrawn tax-free at any time. If the account had been open for at least five years when the account holder died, earnings from an inherited Roth can likewise be withdrawn tax-free.
What happens to a Roth IRA when the owner dies?
After you die, you must take distributions from your Roth IRA. You have control over how the funds are distributed after your death. You name the beneficiaries, and the funds will be distributed straight to them without going through probate.
If you’ve named a beneficiary, disbursements must begin at least one year after your death. Annual distributions must be in an amount equal to the Roth IRA account balance multiplied by a fraction with one as the numerator and your beneficiary’s life expectancy as the denominator, but not less than the Roth IRA account balance multiplied by a fraction with one as the numerator and your beneficiary’s life expectancy as the denominator.
Distributions must be fulfilled within five years if you have not specified a beneficiary. If your spouse is your primary beneficiary, he or she has the option of inheriting your Roth IRA or rolling it over to a Roth IRA in his or her name.
If your estate, including the remaining amount in the Roth IRA, is considerable, the amount in your Roth IRA at the time of your death may be liable to estate tax. If you suspect your estate may be that large, you should speak with a tax professional.
Spouses get the most leeway
If a survivor inherits an IRA from their deceased spouse, they have numerous options for how to spend it:
- Roll the IRA over into another account, such as another IRA or a qualified employment plan, such as a 403(b) plan, as if it were your own.
Depending on your age, you may be compelled to take required minimum distributions if you are the lone beneficiary and regard the IRA as your own. However, in certain instances, you may be able to avoid making a withdrawal.
“When it comes to IRAs inherited from a spouse, Frank St. Onge, an enrolled agent with Total Financial Planning, LLC in the Detroit region, says, “If you were not interested in pulling money out at this time, you could let that money continue to grow in the IRA until you reach age 72.”
Furthermore, couples “are permitted to roll their IRA into a personal account. That brings everything back to normal. They can now choose their own successor beneficiary and manage the IRA as if it were their own, according to Carol Tully, CPA, principal at Wolf & Co. in Boston.
The IRS has more information on your options, including what you can do with a Roth IRA, which has different regulations than ordinary IRAs.
Choose when to take your money
If you’ve inherited an IRA, you’ll need to move quickly to prevent violating IRS regulations. You can roll over the inherited IRA into your own account if you’re the surviving spouse, but no one else will be able to do so. You’ll also have several more alternatives for receiving the funds.
If you’re the spouse of the original IRA owner, chronically ill or disabled, a minor kid, or not fewer than 10 years younger than the original owner, you have more alternatives as an inheritor. If you don’t fit into one of these groups, you must follow a different set of guidelines.
- The “stretch option,” which keeps the funds in the IRA for as long as feasible, allows you to take distributions over your life expectancy.
- You must liquidate the account within five years of the original owner’s death if you do not do so.
The stretch IRA is a tax-advantaged version of the pot of gold at the end of the rainbow. The opportunity to shield cash from taxation while they potentially increase for decades is hidden beneath layers of rules and red tape.
As part of the five-year rule, the beneficiary is compelled to take money out of the IRA over time in the second choice. Unless the IRA is a Roth, in which case taxes were paid before money was put into the account, this can add up to a colossal income tax burden for large IRAs.
Prior to 2020, these inherited IRA options were available to everyone. With the passage of the SECURE Act in late 2019, persons who are not in the first category (spouses and others) will be required to remove the whole balance of their IRA in 10 years and liquidate the account. Annual statutory minimum distributions apply to withdrawals.
When deciding how to take withdrawals, keep in mind the legal obligations while weighing the tax implications of withdrawals against the benefits of letting the money grow over time.
More information on mandatory minimum distributions can be found on the IRS website.
Be aware of year-of-death required distributions
Another challenge for conventional IRA recipients is determining if the benefactor took his or her required minimum distribution (RMD) in the year of death. If the original account owner hasn’t done so, the beneficiary is responsible for ensuring that the minimum is satisfied.
“Let’s imagine your father passes away on January 24 and leaves you his IRA. He probably hadn’t gotten around to distributing his money yet. If the original owner did not take it out, the recipient is responsible for doing so. If you don’t know about it or fail to do it, Choate warns you’ll face a penalty of 50% of the money not dispersed.
Not unexpectedly, if someone dies late in the year, this can be an issue. The deadline for taking the RMD for that year is the last day of the calendar year.
“If your father dies on Christmas Day and hasn’t taken out the distribution, you might not even realize you own the account until it’s too late to take out the distribution for that year,” she explains.
There is no year-of-death compulsory distribution if the deceased was not yet required to take distributions.
Take the tax break coming to you
Depending on the form of IRA, it may be taxable. You won’t have to pay taxes if you inherit a Roth IRA. With a regular IRA, however, any money you remove is taxed as ordinary income.
Inheritors of an IRA will receive an income tax deduction for the estate taxes paid on the account if the estate is subject to the estate tax. The taxable income produced by the deceased (but not collected by him or her) is referred to as “income derived from the estate of a deceased person.”
“It’s taxable income when you receive a payout from an IRA,” Choate explains. “However, because that person’s estate had to pay a federal estate tax, you can deduct the estate taxes paid on the IRA from your income taxes. You may have $1 million in earnings and a $350,000 deduction to offset that.”
“It doesn’t have to be you who paid the taxes; it simply has to be someone,” she explains.
The estate tax will apply to estates valued more than $12.06 million in 2022, up from $11.70 million in 2020.
Don’t ignore beneficiary forms
An estate plan can be ruined by an ambiguous, incomplete, or absent designated beneficiary form.
“When you inquire who their beneficiary is, they believe they already know. The form, however, hasn’t been completed or isn’t on file with the custodian. “This causes a slew of issues,” Tully explains.
If no chosen beneficiary form is completed and the account is transferred to the estate, the beneficiary will be subject to the five-year rule for account disbursements.
The form’s simplicity can be deceiving. Large sums of money can be directed with just a few bits of information.
Improperly drafted trusts can be bad news
A trust can be named as the principal beneficiary of an IRA. It’s also possible that something terrible will happen. A trust can unknowingly limit the alternatives available to beneficiaries if it is set up wrongly.
According to Tully, if the trust’s terms aren’t correctly crafted, certain custodians won’t be able to look through the trust to establish the qualified beneficiaries, triggering the IRA’s expedited distribution restrictions.
According to Choate, the trust should be drafted by a lawyer “who is familiar with the regulations for leaving IRAs to trusts.”
How can I avoid paying taxes on my Roth IRA?
The money you put into a Roth IRA is taxed, but the investment earnings in the account are tax-free. Withdrawals are also tax-free once you reach age 591/2 and have kept the account open for at least five years.
Can a trust inherit a Roth IRA?
Designating a living trust as the beneficiary of your Roth IRA can potentially benefit your heirs if money remain in the Roth after your death.
Is it better to inherit a Roth or traditional IRA?
According to conventional knowledge, inheriting a Roth IRA is always preferable to inheriting a standard IRA. In the first situation, distributions are tax-free, but in the second case, distributions are taxed as regular income.
However, experts warn that IRA account holders particularly those who wish to convert their accounts to Roth IRAs should decide whether tax-free or taxable income is preferable.
“Because a Roth is tax-free, people naturally assume that inheriting a tax-free account is preferable to inheriting a pretax IRA,” Michael Kitces, creator of the Nerd’s Eye View blog, explains. “Which, legally speaking, is ‘true,’ but only if you overlook the taxes you paid up front to establish that Roth, which is a genuine expense that should be included.” It’s possible, he argues, that the original IRA owner paid more in taxes to create that Roth than the beneficiary would have paid if the IRA had been passed down without taxes.
The distribution from a traditional IRA that is converted to a Roth IRA must be taxed.
Others argue that inheriting a Roth IRA isn’t necessarily the most advantageous option. “When it comes to the Roth, we’ve always been on the’show me’ side,” says Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research in San Francisco. “Especially in the situation of upfront conversions, when the burden of evidence is considerably larger.”
So, how do you know if you should convert a regular IRA to a Roth IRA before passing assets along to loved ones and heirs?
“No matter who makes the withdrawal the original owner or beneficiary,” adds Spiegelman, “the basic rule for Roth IRA contributions/conversions remains true.” “A Roth makes sense when the income tax bracket at the time of distribution is the same or higher than the income tax bracket at the time of contribution/conversion,” says the author.
Others argue that the issue is one of tax rates. “Whenever your rates are lower, you should pay your taxes,” Kitces advises. “The Roth decision is purely and fully a tax-motivated one,” says John Kilroy, a certified public accountant in the Philadelphia area.
- Bequeath a Roth if your children’s rates are greater. If the kids’ tax rates are higher for example, if they are business owners, lawyers, doctors, or other professionals then let the parents convert at their lower rates and leave the kids with a Roth.
- Bequeath a traditional IRA if your parents’ rates are higher. If, on the other hand, the parents’ tax rates are higher say, they have a large net worth and the kids are 20-somethings struggling to find work at all and in the lowest tax brackets Kitces suggests simply leaving them a “large pretax account and letting them liquidate themselves at their own tax rates.”
- Bequeath a Roth if tax rates are equal. According to Kitces, there is a tiny bias in favor of converting to a Roth, mostly to avoid required minimum distributions (RMDs) that apply to the parents while they are still alive, which would increase their tax burden. “It’s a tiny gain for most people, but it’s better than nothing if tax rates are equal,” Kitces says.
- Caveats. These generic rules of thumb, to be fair, make a few assumptions. For one thing, they assume that the money isn’t needed by the parents and that the IRA was set aside for inheritance in the first place. “Otherwise, it’s about the parents’ future tax rates, not the kids’ rates,” Kitces argues.
And, according to Kitces, they presume there is no state estate tax, which can further complicate the situation.
In the case of a taxable inheritance one that exceeds the $5.45 million exemption limit per individual Spiegelman believes a Roth conversion may still make sense if the lower estate taxes result in more net inherited assets, regardless of relative income tax brackets.
- There is no such thing as a crystal ball. According to Kilroy, no one can forecast the future of our tax structure. As a result, he recommends converting some regular IRAs to Roths over time, but not all of them. Beneficiaries would inherit both standard and Roth IRAs in this way. “Given the irregular nature of our tax structure, I’m more convinced that putting all of one’s retirement eggs in one basket (pretax or Roth) is a bad idea.”
- No one gets it properly the first time. “Parents sometimes underestimate the tax bracket of their beneficiaries,” says Joseph Clark, managing partner of Anderson, Indiana-based The Financial Enhancement Group. “In my experience, parents are frequently in a lower tax bracket than their children when they retire.” Again, it’s all about tax sensitivity.”
- Don’t worry about it. “The debate is probably moot for 99 percent of the people,” argues Spiegelman. “An inheritance in any form would be a blessing for most people, especially if it’s tax-free.”
How long can you keep an inherited Roth IRA?
You can do the following if you inherit a Roth IRA from a parent or non-spouse who died in 2020 or later:
- Open an inherited IRA and take out all of the money within ten years. RMDs are not required, however the maximum distribution term is ten years.
- Open an inherited IRA and defer RMDs for the rest of your life. If you qualify as an eligible designated beneficiary, you can do so.
You can do the following if you inherited a Roth IRA from a parent or non-spouse who died in 2019 or earlier:
- Take RMDs from an inherited IRA. RMDs can be spread out over your lifetime, which is an excellent method to maximize the tax-free growth of your money.
- Create an inherited IRA and take the money out within five years. If you withdraw all of your money within five years, no RMDs are required.
You have the option of receiving a lump-sum payment regardless of when your loved one died. If your IRA has been open for at least five years, you will not have to pay income tax or a penalty.
What is the 5 year rule for inherited Roth IRA?
A five-year inheritance rule applies to a Roth IRA. By December 31 of the year following the owner’s death, the beneficiary must have liquidated the whole value of the inherited IRA.
During the five-year period, no RMDs are necessary. For example, if Ron passes away in 2021, his Roth IRA will be left to his daughter Ramona. If she chooses the five-year payout, she will be required to distribute all of her assets by December 31, 2026.
All withdrawals from an inherited Roth IRA that has been in existence for more than five years will be tax-free to the beneficiary. Furthermore, the tax-free distribution can consist of either earnings or principal. Withdrawals of earnings are taxable for beneficiaries of a fund that hasn’t met the five-year mark, but the principle isn’t.
What is the downside of a Roth IRA?
- Roth IRAs provide a number of advantages, such as tax-free growth, tax-free withdrawals in retirement, and no required minimum distributions, but they also have disadvantages.
- One significant disadvantage is that Roth IRA contributions are made after-tax dollars, so there is no tax deduction in the year of the contribution.
- Another disadvantage is that account earnings cannot be withdrawn until at least five years have passed since the initial contribution.
- If you’re in your late forties or fifties, this five-year rule may make Roths less appealing.
- Tax-free distributions from Roth IRAs may not be beneficial if you are in a lower income tax bracket when you retire.
What happens when you inherit an IRA from a parent?
Many people believe that they can roll over an inherited IRA into their own. You cannot roll an IRA into your own IRA or treat it as your own if you inherit one from a parent, aunt, uncle, sibling, or acquaintance. Instead, you’ll have to put your share of the assets into a new IRA that’s been established up and properly labeled as an inherited IRA for example, (name of dead owner) for the benefit of (name of deceased owner) (your name).
If your mother’s IRA account has more than one beneficiary, money can be divided into separate accounts for each. When you split an account, each beneficiary can treat their inherited half as if they were the only one.
An inherited IRA can be set up with almost any bank or brokerage firm. The simplest choice, though, is to open your inherited IRA with the same business that handled your mother’s account.
Most (but not all) IRA beneficiaries must drain an inherited IRA within 10 years of the account owner’s death, thanks to the Secure Act, which was signed into law in December 2019. If the owner died after December 31, 2019, this rule applies to inherited IRAs.
What is the 10-year rule on inherited IRA?
“According to the 10-year rule, IRA beneficiaries who are not receiving life expectancy payments must withdraw the whole balance of the IRA by December 31 of the year after the owner’s death.”
Can you have 2 ROTH IRAs?
How many Roth IRAs do you have? The number of IRAs you can have is unrestricted. You can even have multiples of the same IRA kind, such as Roth IRAs, SEP IRAs, and regular IRAs. If you choose, you can split that money between IRA kinds in any given year.