Roth IRA's are a bit quirky. Roth IRAs have special rules that traditional IRA's don't have such as no required minimum distributions or you can fund a Roth IRA beyond age 70 as long as you have earnings and are under the income limitations. Roth IRAs also have a minimum 5-year holding period for a distribution to be considered qualified, unlike traditional IRAs. A Roth qualified distribution means the earnings and the principal are withdrawn tax-free. If the distribution is not qualified, then the earnings are taxable upon withdraw.
Generally speaking if the surviving spouse is the sole primary beneficiary of a Roth IRA, then like a traditional IRA, the surviving spouse can rollover or transfer the inherited IRA to his/her own Roth IRA. However, special attention needs to be paid to the 5-year waiting period for a distribution to be considered qualified. Talk about quirky! To help survivors make heads or tails of Roth accounts, here are five planning considerations to be aware of when and if you inherit a Roth IRA.
1. Beneficiaries of Service-person Group Life Insurance (SGLI)
are allowed to roll the life insurance proceeds into a Roth IRA, regardless of income and contribution limits. While there is no monetary reward large enough to make up for the loss of life, Congress is hoping this special rule helps ease the financial stress of survivors. For example, if the life insurance payment from a SGLI policy is $400,000 then the entire $400,000 can go into a Roth IRA. This will help continue the tax-deferral of the monies inherited (meaning there are no income taxes paid on the earnings generated in a Roth IRA, which could help you grow money faster over time). There are some caveats such as the transaction has to be done in one year from the date you receive the SGLI benefit. You can also elect to have some and not all of the SGLI benefits go into the Roth IRA.
2. Qualified Distributions for an inherited Roth IRA start January 1
of the first year for which the owner made a contribution - whether a regular contribution or a Roth conversion contribution. This is important because Qualified Distributions are completely tax-free, meaning there is no 10% early distribution penalty and the earnings are tax-free. Some other thoughts on the 5-year rule include:
- The 5-year period starts when the Roth IRA owner makes a contribution, it does not restart when the beneficiary inherits the Roth IRA
- The 5-year period for an inherited Roth IRA is independent from an individual's own Roth IRA holding period. This means if you have a separate Roth IRA, you should keep track of that holding period separately from the inherited Roth IRA's holding period.
Make sure you meet the 5-year rule before you withdraw Roth IRA money so the earnings are not taxable.
3. For a spousal beneficiary who elects to treat an inherited Roth IRA as his/her own and already owns a Roth IRA...
the 5-year period starts with the earlier of the year which he/she made a contribution to their own Roth IRA or the year which the deceased spouse made a contribution to a Roth IRA. Obviously this can help a surviving spouse accelerate the 5 years if the spouse started the Roth IRA sooner.
4. Multiple non-spouse beneficiaries of the same Roth IRA can create separate inherited Roth accounts.
This will enable each beneficiary to use their own life expectancy for the required distributions. Younger beneficiaries will be able to stretch the distribution out further than older beneficiaries due to the longer life expectancy.
5. A 50% excess penalty applies to any required distribution that are not taken from the inherited Roth IRA by the applicable deadline.
This is similar to the penalty for not taking a Required Minimum Distribution from an IRA. The IRS may waive the penalty if the deadline was missed due to a reasonable cause.
As you can see, there are special planning considerations unique to inherited Roth IRAs. Time spent understanding these special rules can help ensure your distributions are qualified or can further stretch out the tax-free growth of the Roth IRA and leave a larger legacy for the next generation. For more information or if you have questions about inheriting an IRA or Roth IRA, please feel free to email me.