The Roth IRA Tax Rules for Heirs

A Roth IRA is, quite possibly, one of the best inheritances ever. After all, everybody loves a big chunk of tax-free cash. Plus, you have options when it comes to disbursement -- a lump sum or a lifetime annuity -- and each has benefits and drawbacks. With a few decisions to make and rules to follow, you can ensure your dearly departed's precious gift meets its full potential.

Required Distributions

The biggest difference between an inherited Roth IRA and your own Roth is the distribution requirement. Unlike a personal Roth account, you must take withdrawals from an inherited account. You can do this in one of two ways: a lump sum or an annuity. If you take a lump sum, you're just emptying out the account, and you have the money to use as you please. If you choose this option, you must take all of the money by December 31 of the fifth year following the original owner's death. During that five years, you can take all of the money at once or in pieces, whatever works best for you. You can also take the annuity option. In this case, you take annual distributions over your entire life expectancy. The advantage of this option is that investments in the account grow tax-free. The disadvantage is that you're locked in. Once you reach the sixth year, you must take an annual distribution based on the Required Minimum Distribution calculation, and only that required minimum. If you fail to take a distribution in any year, or if you don't take the full required amount, you may face a 50 percent tax penalty on the undistributed funds.

Account Management

Once you inherit a Roth IRA, the account is yours to manage as you see fit. This means that you can change account custodians, investment managers and investment options to suit your personal needs. If you co-inherit the account with someone else, you may request that the account be split into individual accounts for each heir. You can combine this Roth IRA with any other Roth IRA you inherit from the same person, but you can't combine the account with any other Roth account, whether inherited or personal.

Five-Year Rule

For the most part, distributions from an inherited Roth IRA are qualified distributions: not subject to specific rules or eligible for tax penalties. The five-year rule is the one exception, and it works just as it does with your own personal Roth account. Any money removed before January 1 of the fifth year following the account opening date is a non-qualified distribution. In the same way, you can't remove any funds in the account that were converted from a traditional IRA or other retirement plan prior to January 1 of the fifth year following the conversion deposit. The original Roth custodian or investment manager can provide you with dates and documentation for account opening and conversions. If you do take a non-qualified distribution, its value will be added to your gross income for the year and may be subject to a 10 percent tax penalty. If you have any questions about the status of your inheritance, talk it over with a tax professional or the account custodian.

Spousal Exception

If you inherit a Roth account from your spouse, you have two additional options when it comes to distributions. First, you can elect to treat the account as your own. In this case, you rename the account with your name and go on as if you've always owned the Roth. If you choose this option, you may combine the account with other Roth IRAs that you own, if you like. The second option is to delay required distributions. Here, you wait until your spouse would have been 70 1/2 to take your first required distribution, and then take annual distributions each year thereafter. In this case, the account is separate for record-keeping purposes.

 

About the Author

Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.