Roth IRA Beneficiary Rules
A Roth IRA is an individual retirement account or a type of account that may be established for the purpose of saving funds for retirement.
It was founded in the year of 1997 and it derived its name from former Delaware Senator, William Roth.
Contributions to such accounts are not tax-deductible, but withdrawals made during retirement will be 100% tax-free after age 59 ½.
Normally, there is a 10% federal tax penalty imposed on early withdrawals if you withdraw before you reach the age of 591/2 years old.
The only exception exempts distributions due to death and disability and certain qualified first-time home purchases.
Key Features of Roth IRA
- Taxes will be paid for contributions made into the account but all future withdrawals are tax-free.
- The contribution limits to a Roth IRA account in 2021 are $140,000 for singles and $208,000 for married couples.
- Roth IRA owners are not mandated to take distributions from their accounts at any age.
- There are no required minimum distributions (RMDs) set for Roth IRA accounts just like the traditional IRA and 401(k) plans.
- The Roth IRA has the same tax advantages as traditional IRAs, but with additional benefits.
- A Roth IRA account is very flexible and investors have more options in terms of where they invest their funds.
What Is an Inherited Roth IRA?
An inherited Roth IRA is an individual retirement account that has been passed on to someone else through the process of death.
The beneficiary of the account is responsible for taxes and future distributions.
Roth IRAs are usually established by investors during their working years, but there may be times when they pass on prior to reaching retirement age.
This will leave it up to the beneficiaries to either close the account or continue making contributions, just like any other inherited traditional IRA.
What Is Considered as a Roth IRA Distribution?
It is considered as a withdrawal, disbursement, or other taxable events from your Roth IRA when any money comes out of your Roth IRA Account.
Distribution Rules for Inherited Roth IRA
Inheriting a Roth IRA is an event that triggers some different rules from those of a regular Roth IRA.
Generally, withdrawals made from the inherited Roth IRA account are not subject to tax and penalties because originally, contributions made into the account have already been initially taxed.
However, according to the five-year rule, only withdrawals made from an account that was opened at least five years ago are tax-free.
Thus, all other withdrawals from Roth IRA accounts that are less than five years old are subject to income tax plus penalty.
The SECURE (Setting Every Community Up for Retirement Enhancement) Act has made changes as to the time period of distributions for an inherited IRA.
If the owner of the Roth IRA account died before December 31, 2019, the old rules of distribution will apply. If death was in 2020 or later, the beneficiary doesn’t have to take the required minimum distributions but is required to exhaust the entire Roth IRA account within 10 years.
An exception to this is the case for “eligible designated beneficiaries.” These beneficiaries are allowed to stretch the distributions over their lifetime. Eligible designated beneficiaries include:
- Spouse of the deceased Roth IRA owner
- Minor child of the deceased Roth IRA owner
- Chronically ill or disabled beneficiaries
Inheriting Roth IRA From Spouse
Here are some options for beneficiaries of inherited Roth IRA from a deceased spouse:
Open an Inherited IRA Account
A beneficiary from a deceased spouse has the option to open a separate IRA under a special account called inherited IRA.
Required minimum distributions are still to be made from the inherited IRA account but the beneficiary has the option to stretch them out over his or her lifetime or life expectancy.
Transfer the Inherited IRA to Own Existing IRA Account
A beneficiary can make the decision to transfer the inherited Roth IRA account into his or her existing IRA account. This is only applicable to sole beneficiaries.
This option is available because an inheritor of a Roth IRA does not have to wait until the end of the year that follows after he or she has been notified about inheriting an IRA from a deceased spouse.
If a beneficiary chooses this option, taxes will be collected at their ordinary income tax rate and penalties will apply if any withdrawals are made before reaching the age of 59 1/2 years.
Take a Lump-Sum Distribution
Given that the Roth IRA has been existent for at least five years, no taxes shall be collected if a beneficiary chooses to receive the IRA funds in cash.
If the Roth IRA is less than five years old, taxes will apply.
Inheriting Roth IRA From a Parent
Options under this situation are less flexible compared to inheriting Roth IRA from a spouse.
This situation is further divided into two, following the passage of the SECURE Act:
If a Roth IRA Was Inherited From a Parent Who Died Before 2020:
The beneficiary may have the option to open an inherited IRA and take out the funds within a period of five years.
Conversely, just like that of a spouse, the beneficiary may also opt to open an inherited IRA account and have the required minimum distributions stretched over his lifetime.
If a Roth IRA Was Inherited From a Parent Who Died in 2020 or Later:
The beneficiary may open an inherited Roth IRA account and have all the funds withdrawn within a period of ten years.
If the beneficiary qualifies as an eligible designated beneficiary, he may opt to open an inherited IRA account and have the required minimum distributions stretched over his lifetime.
The Bottom Line
Roth IRAs are retirement accounts with contributions that are initially taxed and future withdrawals are tax-free.
Roth IRAs may be passed on to beneficiaries in the event of the original owner’s death.
Several rules and regulations need to be observed in managing inherited Roth IRAs. Thus, it is best to familiarize oneself with these.
Consulting with a financial advisor will also be very helpful to make sure that a beneficiary handles the inherited Roth IRA within set rules and regulations to avoid mistakes and possible penalties in the future.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.