Inheriting a Roth IRA can provide you with a financial windfall. However, there are rules you must follow so you don’t end up paying additional taxes on the money you’ve inherited.
Prior to the passage of the SECURE Act in 2019, inherited Roth IRA beneficiaries could use the stretch IRA strategy and spread out distributions from an inherited Roth IRA over their lifetimes.
There are new rules—which we’ll talk about here—that govern accounts where the owner died in 2020 or later.
What Is a Roth IRA?
Roth IRAs are a type of individual retirement account. Roth IRA contributions are made with money that’s already been taxed, and withdrawals are generally tax free. Contrast this with a traditional IRA, where contributions are tax free and you owe income taxes on withdrawals.
Roth IRAs lack required minimum distributions—owners can leave money in the account without ever withdrawing a single cent. Traditional IRAs require account holders to start taking out money somewhere between the ages of 70½ and 75, depending on the year they were born.
What Is an Inherited Roth IRA?
An inherited Roth IRA isn’t a special type of account. The name simply refers to the status of a Roth IRA that has been inherited by a beneficiary after the original owner passes away.
As the new owner of the Roth IRA, a beneficiary can get the same tax-advantaged treatment as the original account owner and make regular withdrawals without paying penalties or taxes.
Although the original owner of a Roth IRA never has to take RMDs, that’s not necessarily the case for beneficiaries. People who inherit a Roth IRA have to make important choices about how to manage the account over the long term.
There are special RMD rules for inherited Roth IRAs that depend on things like their relationship to the original account holder.
As a penalty for not taking inherited Roth IRA RMDs when you’re supposed to—that is, for leaving money in the account longer than allowed—you’ll have to pay the IRS up to 25% of the amount you should have distributed for that year if the distribution should have been taken in 2023 or later. For 2022 and earlier, the penalty is 50%.
Inheriting a Roth IRA From Your Spouse
Following the passage of the SECURE Act in 2019, a spouse who was the sole beneficiary of a Roth IRA could still use the “stretch IRA” strategy to pay out their distributions. This strategy allowed spousal beneficiaries to spread their distributions over their lifetime.
However, most spouses will probably want to take advantage of the option to treat the Roth IRA as their own. This can be done by transferring the money to a new or existing Roth IRA in the surviving spouse’s name.
Spousal Transfer Roth IRA: Best for Most
Doing a spousal transfer means you don’t have to take distributions during your lifetime unless you want to. Assets can keep enjoying tax-deferred growth within the account, and you’ll be able to take distributions from this account as if your spouse’s assets were always your own.
You’ll need to be mindful of the five-year rule, though. If it’s been fewer than five years since Jan. 1 of the year your spouse first contributed to the account, you’ll want to avoid withdrawing investment earnings if possible because you’ll have to pay ordinary income tax on that money.
There’s a good chance you won’t withdraw investment earnings even if the account has been open fewer than five years. IRS rules assume that distributions from Roth accounts first come from a return of contributions, then from conversions and finally from earnings.
You’re most likely to run into an earnings withdrawal tax if the account is small or if you’re taking a large distribution—for example, if you’re cashing out the entire account.
Two More Options for Surviving Spouses
You might be wondering when a spouse would decide to take distributions from an inherited Roth using the life expectancy or “stretch” method. If you’re younger than 59½ and want to be able to withdraw earnings without paying a 10% penalty, you could use this option by opening an inherited Roth IRA account.
You’d then be committing yourself to RMDs starting when your deceased spouse would have turned 73 or by Dec. 31 of the year following your spouse’s death, whichever is later.
In this scenario, it might be better in the long run to pay the penalty and keep your flexibility on whether and when to take distributions. It’s a question worth exploring with a fee-only certified financial planner who has no financial interest in which option you choose.
A third option for a sole beneficiary spouse is to open an inherited Roth IRA and use the 10-year distribution method. This option lets you withdraw as much or as little as you want as long as you take all the money out by Dec. 31 of the 10th year following your spouse’s death.
The five-year rule mentioned earlier applies to the lifetime and 10-year distribution methods as well.
Inheriting a Roth IRA From Someone Else
Designated Beneficiary
If you’re not the spouse of the deceased but you were still named as the beneficiary of a Roth IRA—not through their estate, but through a transfer on death designation filed with the financial institution holding the Roth—then you’re a designated beneficiary.
In this case, you can’t just transfer the money to your own Roth IRA like you would as a surviving spouse. You have to open a beneficial designated Roth IRA account.
The deceased’s Roth IRA assets must go directly from their account to yours in what’s called a trustee-to-trustee transfer. Any other transfer process will be considered a distribution, which could be an incredibly costly mistake.
With an inherited Roth, you can’t do an indirect rollover like you might have done when moving a 401(k) from a former employer.
As a designated beneficiary, you’ll have until Dec. 31 of the 10th year following the former account holder’s death to empty the account.
Eligible Designated Beneficiary
Other than spouses, eligible designated beneficiaries are designated beneficiaries who fall into one of three categories:
- Fewer than 10 years younger than the deceased. A friend, sibling or cousin might fall into this category. A beneficiary who is older than the deceased was (a parent, aunt or uncle, for example) would also qualify.
- Chronically ill or permanently disabled. You need ongoing help with at least two activities of daily living or you can’t work enough to support yourself because of your physical or mental condition.
- Minor child of the deceased. A child younger than 21 can take annual distributions based on their life expectancy until reaching age 21. At that point, the child becomes a regular designated beneficiary and has 10 years from Dec. 31 of the year following their 21st birthday to empty the account.
An eligible designated beneficiary can take distributions as a lump sum, using the 10-year method or using the life-expectancy method. In any of these situations, distributions must begin by Dec. 31 of the year following the decedent’s death.
Non-Designated Beneficiary
An estate, non-qualified trust or charity can also inherit a Roth IRA. For example, if the deceased did not name a beneficiary and has no spouse—or if the named beneficiaries are also deceased—the estate might inherit the Roth IRA by default.
Inheriting a Roth IRA as a non-designated beneficiary is the least desirable option. These beneficiaries only have five years to empty the inherited account.
Leaving a Roth IRA to a Trust
Some might choose to leave their IRA to a trust whose beneficiary is a minor child, dependent adult or irresponsible adult. Creditor protection for the time the IRA money remains in the trust is another reason to consider this option.
A trust still has to distribute Roth IRA assets. Those distributions may be held within an accumulation trust or passed to beneficiaries through a conduit trust with differing tax consequences.
A see-through (or look-through) trust gets 10 years to distribute all of the Roth IRA assets. A non-see-through trust only gets five years.
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