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The tax ramifications of an inherited Roth IRA
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"Be sure to read the fine print."
It's neither complex, nor profound advice. Yet, it isn't easy advice to follow when you are navigating your way through pages of IRS rules and regulations governing the way you manage your retirement savings plans. It's clear the IRS has not yet discovered the beauty of simplicity.
This is the case with the rules and regulations surrounding the Roth IRA. Although the average investor hasn't memorized IRS Publication 590, Individual Retirement Arrangements (IRAs), there are a few key rules you need to know about your Roth IRA that can help you avoid making some mistakes that could cost you or your beneficiaries down the road.
What is a Roth IRA?
Unlike a traditional IRA, the Roth IRA offers no deduction for contributions (which are made with after-tax money). All of the tax benefits associated with a Roth IRA happen when withdrawals are made. Subject to certain rules and qualifications, withdrawals are not taxed at all. Once you put your money in, you never pay taxes on that money again if you make qualified withdrawals.
An estate planning tool
Because there is no required minimum distribution for the owner of a Roth IRA, it is possible to use the Roth IRA as an estate planning tool and pass on significant funds to your heirs. While your beneficiaries may have to pay estate taxes on the value of the Roth IRA, no part of the Roth IRA will be subject to income tax to your beneficiaries. Because Roth IRA earnings are not subject to income tax (to you or your heirs), much of the tax burden is eliminated.
But here’s the caveat: The biggest problem with Roth IRAs is that beneficiaries may be required to take distributions. Although the Roth IRA is not subject to required minimum distribution rules for the account owner, it is important to point out that required minimum distribution rules apply for non-spouse beneficiaries. In fact, if the beneficiary of a Roth IRA waits too long before deciding how to handle the funds, he or she could wind up with a big tax bill down the road.
Spousal beneficiary
If a spouse is listed as the beneficiary of a Roth IRA, upon the owner’s death, he or she keeps the Roth IRA intact or elects to roll the Roth IRA over to his or her own Roth IRA. In either case, the spouse would not be required to take any distributions during his or her lifetime and would be allowed to designate new beneficiaries.
Non-spousal beneficiary
One who is not the spouse of the Roth IRA owner is subject to different rules. A non-spousal beneficiary must take full distribution either by the end of the year marking the fifth anniversary of the account holder’s death or over the life expectancy of the beneficiary -- starting no later than Dec. 31 of the year following the year the account holder died.
If distributions to the beneficiary do not start by Dec. 31 of the year following the year of the owner’s death, the rule requiring a complete distribution of the plan balance within five years will become effective -- so it’s important to plan accordingly. All qualified distributions would be tax-free. Failure to take the distribution results in a 50 percent penalty of what should have been distributed.
Imagine paying a 50 percent tax when it could have been completely tax-free.
John Larson, ChFC, is a financial advisor at American Express Financial Advisors, Inc. in Merrillville. His column solely represents the opinion of the writer and not necessarily that of The Times. Readers can reach him at (219) 736-8677.
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