What are the rules if you inherit a Roth IRA?
It’s important to know, because an inherited Roth IRA can trigger:
– Estate Taxes, and/or
– Income Taxes
Contrary to conventional wisdom, an inherited Roth IRA does not pass on to its heirs tax free, unless the sole heir is also the deceased owner’s spouse.
Just like any other asset, a Roth IRA is subject to estate taxes.
So if you inherit a Roth IRA as part of an estate large enough to be subject to inheritance taxes, you will likely owe inheritance taxes on the Roth IRA as well.
However, keep in mind that the deceased owner’s original after-tax Roth IRA contributions are NOT subject to estate taxes – only the tax-free earnings generated on those principal contributions.
The 10% Early Withdrawal Penalty
What happens if you inherit a Roth IRA and immediately withdraw some or all of the funds? Is your withdrawal subject to the early withdrawal penalty if you’re under age 59 ½?
According to the Roth IRA withdrawal rules outlined in IRS Publication 590, the 10% early withdrawal penalty is waived if “you are the beneficiary of a deceased IRA owner.”
So if you recently inherited a Roth IRA, you don’t have to worry about triggering a 10% early withdrawal penalty.
Nevertheless, you do need to worry about income taxes.
Generally speaking, the original tax-free contributions of the deceased Roth IRA owner are not subject to income taxes. But the earnings on those contributions are subject to income taxes if the account fails to meet the requirements of the Roth IRA 5 year rule.
So what are the requirements of the 5 year rule?
A Roth IRA meets the 5 year rule requirement on the first day of the fifth tax year after the Roth IRA was opened and funded.
For example, let’s say you opened and funded a Roth IRA on May 5, 2010. Under this scenario, when will your Roth IRA meet the requirements of the 5 year rule?
On January 2, 2015.
Because 5 tax years will have passed since the time the account was opened and funded – 2011, 2012, 2013, 2014, and 2015.
Remember this rule, because it’s an important one to remember if you wish to minimize the tax liability of an inherited Roth IRA.
Also keep in mind that different rules apply to spousal and non-spousal beneficiaries.
If you inherit a Roth IRA from your spouse, you have two options:
- Elect to treat the Roth IRA as your own, or
- Delay your withdrawals until the time when your deceased spouse would have reached age 70 ½
If you elect to treat the Roth IRA as your own, it takes on all the characteristics of your own Roth IRA – the same as if you had opened and funded it yourself.
At this point, simply follow the normal Roth IRA rules, and you can avoid taxes altogether.
Non-principal withdrawals before age 59 ½, or before the requirements of the 5 year rule are met, will trigger an early withdrawal penalty and income taxes, but the original principal contributions can be withdrawn tax-free and penalty-free at any time.
In addition, you can make addition contributions to the inherited Roth IRA (assuming you qualify to make Roth IRA contributions), and you can allow funds to grow tax-free in the Roth IRA for as long as you wish (there’s no minimum distribution age).
Alternatively, you can elect to delay your withdrawals until the time when your spouse would have reached age 70 ½.
Under this scenario, you must begin making annual minimum withdrawals from the inherited Roth IRA starting in the year in which your spouse would have turned age 70 ½.
Essentially, the inherited Roth IRA will take on the same rules governing a Traditional IRA (except you won’t owe income taxes on qualified withdrawals).
If you inherit a Roth IRA from someone other than your spouse, you:
- Can’t treat the Roth IRA as your own
- Can’t make new contributions to the Roth IRA
- Must follow the minimum distribution rules
The first two points are self-explanatory, but what are the minimum distribution rules?
Under the minimum distribution rules, you have two options as a non-spouse beneficiary:
- Take the entire distribution by December 31st of the fifth calendar year following the year of the Roth IRA owner’s death, or
- Receive the entire distribution over a lifetime
Under the first option, you can withdrawal all the funds in the Roth IRA tax-free if you play your cards right.
For instance, assume you inherit a Roth IRA from your dad in 2012. He originally opened the account in 2010, and it’s composed of $10,000 in after-tax contributions and $2,000 in earnings.
You can immediately withdraw the $10,000 principal tax-free and penalty-free. But withdrawal of the $2,000 in earnings will trigger income taxes until the account meets the requirements of the 5 year rule.
On January 2, 2015, you’re free to withdraw the remaining $2,000 without taxes or penalties, because the account will meet the 5 year rule requirements, and you will have successfully withdrawn all of the funds in the account before December 31, 2017 (the fifth calendar year following your father’s death).
Under the second option, you can elect to receive an annuity which pays out over the course of your expected lifetime.
If you choose this option, the length of your expected lifetime is predetermined by IRS tables based on your current age and the current value of the account.
Unless you’re the spouse of a deceased Roth IRA owner who elects to treat the inherited Roth IRA as your own, the tax and legal implications of inheriting a Roth IRA can get extremely complicated.
Even if you manage to avoid inheritance taxes, certain types of withdrawals will be subject to income taxes. And certain actions on your part, such as making a contribution to an inherited Roth IRA as a non-spousal beneficiary, are strictly prohibited.
It is well worth your time and money to seek the guidance of a competent estate attorney, accountant, and/or financial advisor.
“However, keep in mind that the deceased owner’s original after-tax Roth IRA contributions are NOT subject to estate taxes – only the tax-free earnings generated on those principal contributions.” – Guys, you might wish to fact-check this. I am unaware of any asset escaping estate tax like this. i.e. never saw non-spouse inheritance avoid estate tax due to its being deposit vs growth, etc.