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.”
Do beneficiaries pay taxes on inherited Roth IRAs?
Earnings from a Roth IRA inherited by a non-spouse are taxable until the 5-year rule is met. The early withdrawal penalty of 10% will not apply to you. The account’s assets can continue to grow tax-free. You have the option of naming your own beneficiary.
What happens if I inherit a Roth IRA?
When you inherit a Roth IRA, the money you receive is tax-advantaged in the same way that the money in the original account was. Because the funds were contributed after taxes, you can withdraw them at any moment without incurring any tax or penalty.
Withdrawals of earnings are tax-free if the account was started at least five years ago, according to the five-year rule. Earnings taken from Roth IRAs that are less than five years old are taxed at your regular rate plus a penalty.
The SECURE Act altered how the payout time period for an inherited IRA is calculated. You don’t have to take required minimum distributions (RMDs) if your loved one died in 2020 or later, but you must remove the whole value of the IRA within 10 years.
The new law stops you from spreading out your distributions across your lifetime, allowing you to optimize the tax-free growth of your account. The new law does, however, create a new group of recipients known as “qualified designated beneficiaries,” who can still stretch distributions out across their lifetimes. If you meet the following criteria, you are an eligible designated beneficiary:
Do inherited Roth IRAs get a step up in basis?
For tax-deferred accounts, such as Roth IRAs, there is no date of death basis adjustment. If her spouse contributed to a Roth account more than 5 years ago, when he died, the Roth account became eligible and tax-free, as long as she kept it named as an inherited Roth.
How do I avoid paying taxes on an inherited IRA?
With a so-called Roth IRA conversion, IRA owners can transfer their balance from pre-tax to after-tax, paying taxes on both contributions and earnings. “If they’re in a lower tax bracket than their beneficiaries, it would probably make sense,” Schwartz said.
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.”
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.
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 new 10-year rule for inherited IRA?
The following are the most relevant aspects of the “10-year” rule as it relates to the SECURE Act and inherited IRAs:
(1) Non-EDBs have ten years to complete their inherited IRA withdrawals; and
(2) During the 10-year period, non-EDBs are not subject to required minimum distributions (RMDs). In other words, they are not obligated to withdraw a certain amount each year during the course of the 10-year period. They can wait until the 10-year time is up and then withdraw the full inherited IRA account in one big sum.
In March 2021, the IRS released Publication 590-B for 2020, which included a section outlining the 10-year inherited IRA withdrawal rule. The IRS intimated in their explanation that RMDs would be required during the 10-year term, which was not the case.
Publication 590-B was recently updated by the IRS to clarify and rectify its position on the 10-year rule. The IRS specifically indicates that no RMDs are due if a non-inherited EDB’s IRA is fully withdrawn by the end of the 10-year anniversary of the original IRA owner’s death.
Harold, who owned a regular IRA, passed away on July 15, 2020. Vivian, Harold’s adult daughter, had been nominated as the sole beneficiary of his typical IRA. Vivian has until December 31, 2030, to withdraw her inherited IRA funds. Vivian has the option – but not the obligation – to withdraw any amount she wants before December 31, 2030.
The IRS further noted that, while EDBs are still eligible for lifetime distributions from their inherited IRAs based on their life expectancy (thus the term “stretch IRA”), they can choose to use the 10-year rule instead. This is only the case if the IRA owner passed away before the required start date. Individuals born before July 1, 1949, must begin on April 1 of the year in which they turn 70.5; those born after June 30, 1949, must begin on April 1 of the year in which they turn 72.
In some cases, an EDB may prefer the flexibility of the 10-year rule to being bound into a rigorous “stretch IRA” RMD plan each year, even if the time extends beyond the 10-year period.
What is the 10-year rule for 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.”
Should you make your trust the beneficiary of your IRA?
An Individual Retirement Account (IRA) is a self-directed investing account that you own. You can donate up to a set amount of money each year, subject to certain limitations. This contribution is normally deductible from your income in traditional IRAs, and later withdrawals are subject to income taxation. The donation to a Roth IRA is normally not tax deductible, but later withdrawals are tax-free. If you take money out of any form of IRA before turning 59 1/2, you’ll be hit with a 10% early-withdrawal penalty.
When you reach the age of 72, you must begin withdrawing required minimum distributions (RMDs) from your conventional IRA on a yearly basis. The RMDs are calculated using your age and a life expectancy factor found in IRS figures. RMDs are not required for Roth IRAs during your lifetime.
Because of the way the IRS tables are set up, if you just take out the RMDs from your IRA, there will be assets remaining in the account after you die. Furthermore, if your IRA earns a high rate of return on investment, it’s feasible that your IRA will be worth more at your death than when you started taking RMDs.
The IRA, along with its residual assets, does not transfer through your will or trust; instead, it goes to the person you nominated as the IRA beneficiary. Individual designations are the most usual, such as all to a spouse or in equal shares to children. A trust, on the other hand, can be listed as an IRA beneficiary, and in many cases, naming a trust is preferable to selecting an individual.
What is my basis in an inherited Roth IRA?
When you inherit an IRA, your account’s basis is the same as the account’s decedent’s. This is the amount of any nondeductible contributions made to the account in traditional IRAs. Because all Roth IRA contributions are nondeductible, the basis for Roth IRAs is equal to the entire contributions.
For example, if the decedent’s traditional IRA had a $20,000 basis because he made $20,000 in nondeductible contributions throughout the years, your basis is $20,000 as well.