Tax Implications of an Inherited Roth IRA: What You Need to Know

In the event of the demise of a family member, management of their retirement account is not likely to be one of the things that first comes to your mind. However, if you are a beneficiary of the deceased person, it is essential that you figure out what it is to be done with their retirement account. A hasty decision or careless planning may cause further grief in the form of taxes and penalties. This is because each retirement account has its particular terms and conditions when it comes to the withdrawal of funds. It is more than likely that you may have to pay a hefty tax if you happen to breach any of the conditions pertaining to the withdrawal of funds. For example, if you inherited a traditional IRA (Individual Retirement Account), you will have to follow the rules and guidelines enforced by the IRS (Internal Revenue Service) on the usage and distribution of funds from the inherited IRA account. Additionally, you’d be required to take RMDs (Required Minimum Distributions) at regular intervals, otherwise, you may incur hefty penalties until the error is fixed. You also need to take into account the fact that IRA withdrawals are also taxable as ordinary income. For further questions or concerns regarding Roth IRA, it is advisable to consult a financial advisor.

In the case of a Roth IRA account, there is a significant difference when it comes to withdrawing funds from the account. Simply speaking, a Roth IRA is an individual retirement account wherein after-tax contributions are made, it offers tax-free earnings and tax-free withdrawals. So, if you inherited a Roth IRA account, you can make use of the said funds to your benefit. However, there are certain tax implications that you need to abide by, particularly when it comes to your relationship with the original owner of the Roth IRA and the age of the account. If both these conditions are satisfactorily met, you will be able to minimize the tax component of your inheritance.

Let’s discuss some of the important implications of the Roth IRA inheritance tax:

What is meant by an Inherited IRA?

In layman’s terms, an inherited IRA refers to an individual retirement account that is passed on to the listed beneficiary after the death of the original account owner. The beneficiary can be either a spouse, family member, unrelated person, or even a trust, estate, or non-profit organization of the deceased person. IRAs serve as a great estate planning option due to their tax benefits. The tax implications for an inherited IRA come into play when the account is passed on to either a spouse or non-spouse. In addition, the kind of inherited IRA, whether it is a traditional IRA or a Roth IRA also plays an important role in determining the tax implications. If you inherit a traditional IRA account, you would likely have to pay taxes on its distributions, however, if you are a beneficiary of a Roth IRA account, your Roth IRA inheritance tax will be minimum, provided you meet certain conditions.

Does one have to pay taxes on an Inherited IRA?

A Roth IRA serves as a valuable estate planning tool wherein the tax implications on the beneficiary are minimal and in certain cases, do not exist at all. A Roth IRA includes after-tax contributions so any withdrawal that you make during retirement is completely tax-free provided the Roth IRA account was owned for at least five years from the year the first contribution was made. Thus, it is highly unlikely that you’ll have to pay any inheritance taxes in the event of you being the beneficiary of a Roth IRA account. However, you may have to pay a small amount of tax on the earnings on the Roth IRA contributions but this may only occur if the distributions from an inherited Roth IRA are taken before the expiry of the five-year holding period.

Consider a scenario wherein you were the recipient of an inherited Roth IRA where the original owner of the account passed away in 2020, and the account was opened in 2015 or earlier. In this case, the entire amount of the Roth IRA account that you would have received as an inheritance would be treated as tax-free. This is because the account fulfilled the criteria of the 5-year holding period as mandated by the IRS. This tax-free status for an inherited Roth IRA would also stand true in a scenario wherein the contribution for the year 2015 was made in 2016 since as per rules, both a traditional IRA and a Roth IRA can be sponsored for a financial year, which can be as late as the tax filing deadline for April.

On the other hand, if you inherited a Roth IRA account that was opened in the following years, 2016, 2017, 2018, 2019, or 2020, and the owner passed away in 2020, the Roth IRA funds would be taxable. However, if you wait till the completion of the 5-year holding period, you would be eligible to receive tax-free distributions. Consider the case wherein a Roth IRA account was opened in 2017. The entire Roth IRA balance would become available tax-free from the year 2022 onwards. If the deceased person made a contribution towards his Roth IRA in the year 2019, then you must wait until 2024 to receive tax-free earnings.

Moreover, this does not mean that you cannot get hold of any tax-free funds from an inherited Roth IRA before the expiry of the 5-year holding period. You can withdraw all the funds from the account except for the Roth IRA earnings. So, when you order your withdrawal, the first distributions are taken out from the regular contributions. The subsequent distributions are taken from conversions and Roth rollovers (per a first-come-first go basis) if any. The last section of the withdrawn funds is composed of earnings on contributions. What this means for you is that you can avoid the Roth IRA inheritance tax before the expiry of the 5-year holding period, provided you only withdraw the contributions and conversions. Speaking of conversions, the 5-year rule doesn’t come into effect if it is an inherited Roth IRA. As per the IRS rules, the beneficiaries of a Roth IRA account are exempt from payment of a 10 percent tax penalty on withdrawal of Roth IRA funds before the reaching age of 59.5.

Enumerate the tax implications on Required Minimum Distributions (RMD) for a Roth IRA

It is mandated by the IRS to take withdrawals from your inherited Roth IRA if you are not a spouse of the deceased person failing which a tax penalty of 50 percent would be levied upon you on the sum not withdrawn. This shall be applicable even in a scenario wherein the distribution does not come under the ambit of taxation originally. Alternatively, if you are a spouse, and treat the inherited account as your own, you would have access to other provisions and exemptions not available to non-spouses.

When it comes to an inherited Roth IRA account, your relationship with the original account owner and when the account owner passed away, plays a major role in the taxable amount that you may or may not have to pay on your inherited Roth IRA.

• Based on your relationship: If the beneficiary of an inherited Roth IRA account is a spouse, the IRS lets the spouse use the funds from the inherited account as theirs only. However, if the beneficiary is not the spouse, then different rules apply to them.
• Based on the death of the account holder: On December 20th, 2019, The Setting Every Community Up for Retirement Enhancement (SECURE) Act, 2019 was enforced wherein the rules for inherited retirement accounts including the Roth IRA, were altered. If your loved one (the original account owner) passed away before December 31, 2019, then the new IRS rules do not apply to you but if the death occurred after the specified date, then they will have to adhere to new distribution rules of the Roth IRA.

What happens when you inherit a Roth IRA from a spouse?

If you inherit a Roth IRA account from your spouse, then you’re subject to different rules as per the IRS. These are as follows:

• You can either designate yourself as the new owner of the inherited account or transfer the sum to your existing Roth IRA account. However, in order to do this, you must be the sole beneficiary of the inherited account. In this instance, you would have to pay a 10 percent penalty and the Roth IRA inheritance tax, if you withdraw the funds before reaching the age of 59.5 years.
• You also have the option to create a special Roth IRA known as the beneficiary IRA wherein you cannot make any contributions to the account however you will be mandated to take RMDs. You can also extend your distributions throughout your lifetime. In addition, you’re exempt from payment of a 10 percent penalty for withdrawing funds before reaching the age of 59.5.
• Unlike a traditional IRA, you can withdraw your Roth IRA distributions in a lump sum. To avail of tax-free withdrawals, the account must have fulfilled the 5-year rule. Moreover, if you choose to withdraw the funds in cash, you forego the opportunity to get tax-free growth on those funds.

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What happens when a non-spouse inherits a Roth IRA?

If a beneficiary receives a Roth IRA inheritance from a non-spouse, the account would not be treated as yours. As per the rules, if you inherit a Roth IRA from a person who has passed away in 2020 or later:

• You can open a Roth IRA account in your name and can transfer the proceeds from the original Roth IRA account into yours. Though, keep in mind that you will be liable to withdraw RMDs beginning from December 31st of the year following the death of the original Roth IRA account holder. In addition, you do not have the discretion of spreading the distributions from this particular account over your lifetime. According to the SECURE Act, all distributions should be made within 10 years of the demise of the original account holder. If there is more than a single beneficiary, the distributions will be carried out as per the life expectancy of the oldest beneficiary. Furthermore, you can withdraw your distributions at any time and the earnings would not be taxed provided the 5-year rule is met.
• If you qualify as an eligible designated beneficiary, then you have the option of opening an inherited Roth IRA account that’ll enable you to spread your distributions over time.

There are certain qualifications that one needs to meet to be considered as an eligible beneficiary. These are:

• You inherited a Roth IRA account from your spouse
• You are a minor child of a Roth IRA account owner
• You have a chronic disability or disease
• There was a 10-year age gap between you and the original Roth IRA account holder

What happens if you inherit a Roth IRA from a person who died in 2019 or earlier?

In such cases, one has the option of:

• Opening an inherited Roth IRA account provided you take out RMDs. Though, you have the option to spread the RMDs over your lifetime to maximize tax-free growth.
• Withdrawing all funds within five years to ensure you don’t have to take any RMDs
• Taking a lump sum distribution for the inherited Roth IRA irrespective of the fact when the original account owner passed away. Moreover, if the account has been active for 5 years, you are not bound to pay any taxes or a penalty regardless of your age at the time of drawing the funds.

To conclude

If you were the beneficiary of a Roth IRA, there are several ways you can maximize your good fortune. You can either leave the assets in the account for as long as possible to take advantage of tax-free growth or create a special Roth IRA account yourself to spread the distributions throughout your life. You can also withdraw your Roth IRA distributions in a lump sum and invest that sum in a financial product or investment of your choice. However, to take full and proper advantage of the Roth IRA inheritance tax benefit, you need to be fully appraised of the specific rules and regulations concerning the matter. It is advised that you seek the guidance of a professional financial advisor who can help you understand these rules and identify opportunities for you to maximize the growth of the money you received as an inheritance. Use the free match tool and get connected with 1-3 advisors that can help you create an effective strategy to grow your finances.