Any time you inherit assets, it’s an appreciated windfall. However, there are times when an unexpected windfall comes with strings attached. This is the case when you inherit an IRA. The rules governing the inheritance of an IRA depend on whether you have a traditional or a Roth account and whether or not you’re the spouse of the deceased IRA owner.
Here are some important details you need to know about inheriting a Roth IRA.
Spousal IRA Inheritance
If you inherit an IRA as the spouse of the original owner, it makes the situation simpler. Jim Limbach, a reporter and editor at Consumer Affairs, points out that if you inherit an IRA from your spouse, it can be treated as your own, as long as you are the sole beneficiary of the IRA.
Limbach also points out that you can designate yourself as the account holder, or you can “treat it as your own by rolling it over into your IRA or, to the extent it is taxable, into a qualified employer plan, qualified annuity plan, tax-sheltered annuity plan, or a deferred compensation plan.”
The rules are much the same if you inherit a Roth IRA as a spouse. You can initiate a spousal transfer that allows you to move the assets into your existing Roth IRA, or you can move the assets into a new Roth you set up. The money is available at any time, much like a “regular” Roth you open (versus an inherited one), but the earnings will likely be taxable until you reach 59 1/2 and the five-year holding period has been met.
When you decide to treat the IRA inherited from your spouse as your own, you can make your own contributions to the account in accordance with the regulations on such accounts. All the regular rules apply when you are able to treat your inherited IRA as your own.
Things get a little stickier, no matter what type of IRA you have, if you aren’t the spouse of the deceased owner, or if you are the spouse and you aren’t the sole beneficiary and have to divide the inheritance with others.
The Inherited IRA
“If you inherit a traditional IRA from anyone other than your deceased spouse, you cannot treat the inherited IRA as your own,” says Limbach. “This means that you cannot make any contributions to the IRA. It also means you cannot roll over any amounts into or out of the inherited IRA.”
When you establish an inherited Roth IRA, you have to choose whether to use the life expectancy method or the five-year method. It’s important to understand these rules, because with your own Roth IRA, there are no Required Minimum Distributions (RMDs). However, with an inherited Roth IRA, there are RMDs, and they may come sooner than expected.
The life expectancy method requires the beneficiary to establish a life expectancy based on existing legislation. Your distributions from the inherited Roth IRA will be spread over your life expectancy, and the RMDs must start no later than December 31 of the year following the year of the original account holder’s death.
If there are multiple beneficiaries to the account, individual inherited Roth IRA accounts need to be established by December 31 of the year following the year of the death. If this doesn’t happen, there is one account, and the RMDs are made based on the life expectancy of the oldest beneficiary.
With this method, the spouse of the deceased has the option to postpone RMDs until the deceased account holder would have reached age 70 1/2.
The five-year method requires all assets from the inherited Roth IRA to be withdrawn by December 31 of the fifth year after the year in which the original account holder died. This pares down the time period quite a bit. You can take distributions as you wish, spreading them out over time, but all of the assets need to be withdrawn from the account within the stated time period.
With both of these methods, it’s possible to take distributions without being taxed, as long as the five-year holding period has been met. Undistributed assets keep growing tax free for as long as the inherited IRA is in force, and you won’t have to worry about the 10% early withdrawal penalty.
With an inherited traditional IRA, it’s important to understand you are taxed on the distributions (or the money you withdraw from the account), since the account is tax deferred and the money hasn’t been taxed yet. Limbach says there might be an estate tax deduction from certain traditional IRA distributions, but it’s important to double-check with a tax professional to understand the process and the possibilities.
Lump Sum Distribution
One of the easiest ways to deal with an inherited Roth IRA is to receive a lump sum distribution, the entire balance at one time. As long as the Roth IRA is at least five years old, you don’t need to worry about taxes on even the earnings, whether you are a spouse or not.
Before taking this option, double-check the age of the Roth IRA, since you could see a bigger tax bill if the account is less than five years old at the time of the original account holder’s death.
If you have questions about the implications of an inherited IRA, whether it’s a traditional IRA or a Roth IRA, consult with a knowledgeable retirement planning expert and/or tax professional.
Have you had experience with an inherited Roth IRA? What are some other tips for handling this situation?