What Happens When You Inherit a Roth IRA?
If you are the spouse of the original account holder, an inheritance Roth allows for tax-free transfer of assets into an inherited Roth.
Other beneficiaries, such as children, chronically ill individuals, and certain trusts have more options when working with a financial professional.
Distributions
An inherited IRA falls under specific IRS rules that differ from traditional and Roth IRAs, specifically regarding its RMDs (Required Minimum Distributions), which must be taken by beneficiaries after a certain timeframe; this timeframe depends on both when their original account holder died and whether or not they had already begun taking RMDs for that year.
Surviving spouses can transfer the account into their IRA without taking distributions; non-spouse beneficiaries, on the other hand, must empty it within 10 years or lose it entirely. Prior to 2020, non-spouse beneficiaries had the option to “stretch out” withdrawals by using IRS life expectancy tables; this has since been discontinued with passage of the 2019 SECURE Act.
The heirs must also decide whether or not to take lump-sum withdrawals, which may have tax implications. Furthermore, they should consider continuing contributions to an IRA as well as meeting Roth IRA’s 5-year holding period before withdrawing earnings withdrawals from earnings withdrawals.
Taxes
The IRS has strict rules regarding Roth IRAs you inherit. In general, you must empty it by Dec 31 of the tenth year following your loved one’s death; otherwise you will incur a 10% penalty.
Surviving spouses enjoy preferential tax treatment when treating an inherited account as their own, with no requirement for taking required minimum distributions (RMDs), but can instead “stretch out” their withdrawals over their lifetimes.
Beneficiaries who qualify for preferential tax treatment also include minors reaching majority, those less than 10 years younger than the original account holder and chronically or permanently disabled people. A fee-only certified financial planner with expertise in IRAs can help you sort through your options while connecting you to an appropriate fiduciary to handle details for you*
Rollover
The IRS provides two options for beneficiaries who inherit Roth IRAs: 1) Direct rollover is where you transfer directly from one IRA into yours without incurring income tax and penalties of 10%, thus saving time. 2) Beneficiaries who receive their inheritance should consider direct rollover as another method to handle it properly and ensure there are no surprises with taxes or penalties later on;
Non-spouse beneficiaries cannot inherit IRA funds directly, so an inherited IRA must be opened. You should then follow both stretch IRA rules for nine years and 10 year rule rules in the last 10. However, this process can be complex and you may need the services of a financial planner in order to navigate it safely.
Gagnon suggests taking a lump-sum distribution and paying taxes on its earnings as another alternative. While this might make sense for minors or those expecting to fall under lower tax brackets in retirement, it might not always be in your best interests, potentially losing decades of tax-deferred growth, according to Gagnon.
Disclaim
An individual inheriting an IRA has several options for dispersing their account, each of which could have different tax repercussions and it is important to consult with a retirement or tax professional in order to understand these implications of each choice.
Before the SECURE Act came into play, nonspouse beneficiaries could use life expectancy calculations to “stretch out” their required minimum distributions over decades and thus avoid an expensive income tax bill when beginning withdrawals.
Under SECURE, nonspouse beneficiaries have 10 years to drain an inherited Roth IRA of its funds, while designated beneficiaries (such as spouses, minor children, chronically ill individuals and trusts ) can extend withdrawals indefinitely, according to Slott.
Beneficiaries who do not meet these criteria have no other choice but to withdraw the money within 10 years, otherwise an income tax penalty will be levied against them. They can, however, disclaim assets that allow them to pass them along to another eligible beneficiary.
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