Understanding the Tax Ramifications of an Inherited Roth IRA
Estate TaxIf a Roth IRA is included in an estate valued under the taxable inheritance minimum, which as of Tax Year 2010 was $3.5 million, no estate tax needs to be paid.
The traditional solution for married households with combined assets exceeding the taxable inheritance minimum, but lower than double the minimum, is the AB trust.
In addition, spouses may continue to contribute to the inherited Roth IRA or merge it with their own Roth IRAs. By doing this, however, the surviving spouse will not be able to withdrawal the earnings tax free until he or she reaches age 59.
The Roth IRA could also be transferred into a foreign trust to avoid domestic taxes, from which the beneficiaries could withdrawal the inheritance.
Another solution requires long-term planning, which divides other assets, such as real estate, equities and cash savings among other beneficiaries prior to death, which can be effective as long as the Roth IRA is not worth more than the taxable inheritance minimum.
Non-Spouse BeneficiariesIf the beneficiary is not a spouse, there are additional limitations to inheriting a Roth IRA.
Firstly, the non-spouse beneficiary is not allowed to make additional contributions to the inherited Roth IRA, or combine it with his or her own Roth IRA. In addition, the beneficiary may elect to choose from one of two methods of distribution.
The first option is to receive the entire distribution by December 31st of the fifth year following the year of the IRA owner’s death. This can be done in order to sidestep income taxes on earnings; in addition, the beneficiary may withdrawal the contributions portion of the IRA other than the accumulated earnings at any time without taxation.
The second option is to receive portions of the IRA as distributions over the beneficiary’s life, terminating upon the death of the beneficiary and passing on to a secondary beneficiary. The distributions will initially come out of the contributions portion of the IRA, and later from the earnings. This is also used to sidestep estate taxes and reduce the annual tax impact.
Income TaxThe first and most important rule to remember regarding income taxes is the five-year rule. A Roth IRA must have been established for at least five years before its earnings can be withdrawn exempt from any income taxes. These earnings become tax-free starting on the first day of the fifth taxable year after the Roth IRA’s establishment. If the early withdrawal of earnings is not due to premature death, a 10% distribution penalty is levied in addition to regular income tax. If it is due the holder’s death, then the 10% distribution penalty does not apply. If the five-year requirement is satisfied, then beneficiaries can take out the Roth IRA’s earnings tax-free, without regard to the ages of the decedent or beneficiary.
Plan AheadThis is a brief outline of the tax ramifications of inherited Roth IRAs, and it is important to plan well in advance in the event of an untimely death, so beneficiaries are not shouldered with confusing taxes, and can receive the fullest amount of the inheritance.
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