Upon the death of a loved one, you may have inherited a Roth IRA as a beneficiary of the estate. There are different rules that apply to a Roth IRA when received as inheritance. First, the federal estate tax will apply to assets owned in a Roth IRA. Additionally, if a Roth IRA was set up in less than five years before a party dies, beneficiaries may have to pay the taxes on earning if funds are withdrawn early.
Understanding Estate Taxes
Roth IRAs are not exempt from estate tax. If, upon your death, you own a Roth IRA and it is bequeathed to a beneficiary other than your spouse, the Roth account will be included in your taxable estate. The federal estate tax is applicable to assets you have at death if the taxable estate is more than the unused part of the unified credit amount.
There is a benefit for estate taxes with the Roth IRA since the account contains after tax funds. The total size of your estate will be reduced by the amount of taxes you have paid on the funds so you will have a smaller taxable estate if if the value of the estate being passed on is greater. Since you have already paid the income tax on the Roth account, your beneficiaries will save. Some people are misled in thinking the savings comes from a special estate tax rule.
Understanding Income Tax on Inherited Roth IRA
The way a Roth IRA handles income tax is basically the same as before a death. However, there are three exceptions to this scenario including:
- For post-death distributions, the 10% early distribution penalty will not apply unless a spouse inheriting the account chooses to keep the Roth IRA as their own.
- The beneficiaries of a Roth IRA can withdraw tax-free earnings even if they are under the age of 59 ½ and if the deceased was under the same age as long as the five-year account time period has been met.
Beneficiaries of the account may be required to take distributions as per the following rules:
- The five year requirement is still in effect for tax-free withdrawals.
- Beneficiaries may have to pay taxes on earnings withdrawals if the account owner’s death and subsequent beneficiary’s withdrawal happen just after the Roth IRA is established. The tax applies to just those earnings accrued after the contribution to the Roth IRA, which is a typically small tax.
- A beneficiary can avoid this taxation if they elect to leave the funds in the Roth IRA account for the required time period.
Beneficiaries Other than Spouse
If you are the beneficiary of a Roth IRA account and are not the spouse of the decedent you will not be allowed to make contributions or use the inherited Roth IRA account in combination with any accounts you have already established.
Distribution rules for non-spouse inheritance of a Roth IRA account will be dependent on when the death occurred in relation to the start date for distributions. Distributions for a non-spouse beneficiary must meet one of the following requirements:
- The beneficiary receives the total distribution by December 31 of the fifth year following the year of the owner’s death
- The beneficiary receives the total distribution over a lifetime, or during a time period not exceeding your life.
The owner of the Roth account may have listed specific applicable rules for the Roth IRA account but typically the decision is left up to those inheriting the account.
Beneficiaries of Spouse
If a Roth IRA is inherited from your own spouse, you have the option to continue using the Roth account as your own. You will be allowed to make regular contributions or conversion contributions to the account. Additionally, distribution requirements for non-spouse beneficiaries do not apply if the account is used as your own fund. The money can be left in the IRA account for as long as you choose but you will not be able to withdraw tax-free earnings without penalty until the age of 59 ½ has been reached.