Inherited Roth IRA Rules

A fully-qualified inherited Roth IRA is the holy grail of estate planning because Roth distributions on inherited Roth IRA’s are

1. completely income-tax free in accordance to regular Roth IRA rules, giving them a major advantage of an inherited Traditional IRA or 401k, and
2. surviving spouses can elect to treat the inherited Roth IRA as their own, meaning no required minimum distributions (RMDs).  By contract, Traditional inherited IRA rules often require the beneficiary to take RMDs.

However, inherited Roth’s do unfortunately count for estate tax purposes.

In regard to paying income tax, there are two exceptions that can effect the tax-ability of the Roth IRA after the death of the account holder:

• As a rule, the 10% penalty for early distribution does not apply in this case, unless the spouse of the deceased opts to handle the Roth IRA as his or her account and then takes an early withdrawal.
• Beneficiaries, including those under age 59½, can withdraw earnings on a tax-free basis if the five-year requirement has been satisfied. For example, tax-free earnings may be withdrawn on January 1, 2015 for a Roth IRA that was established in 2010 or earlier.

This means that a beneficiary may be required to pay taxes on any earnings withdrawn if this event and the original account holder’s death takes place within 5 years of when the account was opened. Note also that the tax is only applicable to the earnings that accrued after the contribution to the account was made. (Usually this is just a small portion of entire IRA since so little time has elapsed.)  A beneficiary can avoid this tax by leaving the earnings in the account until the 5 year period has elapsed.

If you are the beneficiary of a Roth IRA from someone who is not your spouse, you cannot make any contributions to the account or combine it with another Roth IRA that you have already established. In addition, any distributions you make must comply with one the these rules:

• You must receive the total distribution by December 31 of the fifth year after the account holder’s death, or
• You must receive the entire distribution in annual increments over a period that does not extend beyond your life.

In layman’s terms, this means you can elect to either to empty to account completely within 5 years of the account holder’s death or opt to receive annual distributions over your lifetime.  Usually, option 2 is the recommended one.