What Happens When You Inherit a Roth IRA?
By virtue of a recent tax code change, Roth IRA beneficiaries now have more choices; however, those options can be complex and need expert guidance in order to make informed decisions.
As soon as you identify a beneficiary, the first step should be deciding who they will be. Assets inheriting from other people must comply with different rules than original account holders.
Designated Beneficiary
If you inherit a Roth IRA from someone who passed away, there are different rules you must abide by depending on whether they were married to the deceased or not. If they weren’t, however, then you are considered as their designated beneficiary or eligible designated beneficiary (EDB), with funds from their account to yours using what’s known as trustee-to-trustee transfer rules; failing this may cause the IRS to treat this transaction as distribution and tax accordingly.
Roth IRA owners can designate multiple beneficiaries, and you have several distribution options. You could take a lump sum withdrawal, transfer it into an inherited Roth IRA under your own name and begin taking required minimum distributions (RMDs) as per your life expectancy or use the 10-year rule to deplete it before December 31 of the year following your loved one’s passing.
New retirement laws passed in 2019 established the 10-year rule for beneficiaries inheriting Roth accounts. Prior to this point, withdrawals could often be stretched over decades while investments continued growing exponentially. Now if you’re a nonspouse beneficiary you must empty their Roth account within 10 years following their passing or risk incurring substantial income taxes.
Inherited IRAs are subject to federal income tax and, depending on your state of residency, state income tax as well. Any distribution that represents pretax or tax-deductible contributions is taxed at your marginal tax rate while earnings generated through investments are subject to income tax at their marginal tax rates. When making decisions about these assets it is wise to consult both with an accountant and financial advisor in making their best use possible.
Spouse beneficiaries can transfer inherited Roth IRAs directly into their own IRAs, but other beneficiaries don’t enjoy this privilege. If you aren’t the surviving spouse, to keep inherited funds within an inherited IRA account is to withdraw them from the original account holder’s IRA and transfer them over yourself; though doing this may result in taxes being assessed on some portions of distribution but will preserve access to tax-free funds.
If the original account holder had begun taking RMDs, you must continue taking annual RMDs based on your own life expectancy. Furthermore, any investment earnings from an inherited IRA must also be reported and taxed as they come.
Nonspouse beneficiaries such as children or grandchildren who do not meet any of the exceptions listed above must follow the 10-year rule and use up their inheritance by Dec. 31 of 2029 – this represents a dramatic departure from previous law which allowed these nonspouse beneficiaries to spread out withdrawals over their lifetimes. While this change is difficult for nonspouse beneficiaries, planning ahead and choosing appropriate beneficiaries can still minimize tax liabilities; by consulting a financial advisor you can make sure you’re getting maximum benefit out of an inherited Roth IRA!
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