What is an inherited Roth IRA?

An inherited Roth IRA account is a retirement account left to someone after the original account owner’s death. Contributions to a Roth IRA account are made with after-tax dollars, but distributions taken by both the original owner and the inherited owner are not subject to taxes. The handling of an inherited IRA depends on the beneficiary type you are.

Definition and Example of an Inherited Roth IRA

An inherited Roth IRA account is a type of retirement account that the original owner leaves to a beneficiary after their death. The beneficiary can be anyone, although the rules regarding how to handle the account vary depending on the person’s relationship to the original owner.

Alternative Name: Beneficiary Distribution Account (IRA BDA)

An inherited Roth IRA is similar to a standard Roth IRA in that contributions are made using after-tax dollars, but withdrawals and distributions are tax-free, as long as certain conditions are met.

It is customary to meet a five-year holding period before withdrawing funds from the inherited IRA without incurring taxes on earnings. This means that the account must be open for at least five years.

For example, if you inherited a Roth IRA from your spouse and the account was opened more than five years ago, you can inherit the account and receive distributions without early withdrawal penalties (usually 10%) and without paying taxes on the distributions.

If more than five years have passed since the original owner’s first contribution to the Roth IRA, the beneficiary has more options for handling the inherited funds without taxes and penalties.

A beneficiary who was the spouse of the original owner has more options on how to handle the account than non-spousal beneficiaries. For example, they may take a lump-sum distribution or open a new IRA account in their name.

If you are the non-spousal beneficiary of a Roth IRA, you will generally need to open a new Roth IRA account in your name and then transfer the assets from the original account into this new account.

How an Inherited Roth IRA Works

Inherited Roth IRA accounts have different rules than a Roth IRA you own. These rules will vary based on the type of beneficiary you are and when the inheritance occurred.

First, all funds in the account must be distributed within a certain time frame, either five years or 10 years, depending on the year of the account owner’s death.

If you inherit a Roth IRA from a deceased spouse and are the sole beneficiary, you have the most options. You can transfer the funds into your own Roth IRA and continue to grow the retirement account, which can be distributed tax-free after age 59½.

Alternatively, you could also open an inherited Roth IRA in your name and take tax-free distributions at any time. You can also take the money as a lump sum tax-free.

Finally, spousal beneficiaries may choose a distribution method based on life expectancy. This method requires that distributions be made monthly over the beneficiary’s life expectancy, but the funds can continue to grow tax-free.

Often, Roth IRA account owners do not have to take RMDs, or required minimum distributions, like those found in traditional IRAs. However, beneficiaries of an inherited Roth IRA must take RMDs based on traditional IRA rules.

Non-Spousal Beneficiaries

There are two types of non-spousal beneficiaries: eligible designated beneficiaries, which are minor children, chronically ill individuals, permanently disabled individuals, or those who are less than 10 years younger than the original account owner, and designated beneficiaries who do not meet any exception requirements.

With
The SECURE Act has tightened the rules for beneficiaries who inherit a Roth IRA after December 31, 2019. Such parties can no longer treat the inherited Roth IRA as their own by continuing to contribute to it. Instead, the entire accumulated amount or distribution must be taken by the end of the tenth year following the death of the original account holder.

There are no requirements for how to distribute the funds during those 10 years. However, taking a large amount in one year may negatively affect your tax bracket. Qualified designated beneficiaries may also use a distribution method based on life expectancy, but neither of the non-spousal groups can grow in the inherited IRA as they could before the SECURE Act.

Key Takeaways

Inherited Roth IRA accounts are retirement accounts left to a beneficiary where the funds are available for distribution without a tax penalty, provided the five-year holding requirement is met. Due to the SECURE Act, any Roth IRA inherited after December 31, 2019, is subject to stricter rules for non-spousal beneficiaries. If you inherit an IRA from your spouse, you can transfer it into your own IRA and allow the funds to continue growing before taking tax-free distributions at age 59 and a half.

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Sources:

IRS. “Retirement Topics – Beneficiaries.”

IRS. “What if I Withdraw Money from My IRA?”

Schwab. “Rules for Inheriting an IRA.”

IRS. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs).”

IRS. “FAQs on Retirement Plans Related to Required Minimum Distributions.”

Source: https://www.thebalancemoney.com/what-is-an-inherited-roth-ira-5224778