An inheritance can help you get out of debt and pay your upcoming bills. However, if you inherit far more money than you currently need, savings some for a rainy-day fund or retirement can help you get ahead. But just because you have extra money doesn't mean you're eligible to contribute to a Roth IRA. Roth IRAs differ from traditional IRAs because money that goes into a Roth is taxed before it goes in, but when you take a qualified distribution, you remove all the contributions and earnings tax-free.
Inheritence is Not Compensation
To contribute to a Roth IRA, you must have compensation at least equal to your contribution. If your compensation is less than the annual contribution limit, your contribution is limited to the amount of your compensation. Compensation includes only money that you earn from working, either as an employee or as a self-employed individual.
However, the IRS does not require that the compensation be specifically used to contribute to a Roth IRA. For example, if you have $8,000 in compensation and you inherit $50,000, even if that $8,000 went to paying rent and food expenses, you can use money from the inheritance to contribute to a Roth IRA, because you had enough compensation for the year. However, your maximum contribution would be the smaller of your annual contribution limit or $8,000. Don't worry, contributing to a Roth IRA using money from the inheritance rather than money from your compensation won't make the inheritance taxable income.
Income Limits Apply
In addition, your modified adjusted gross income cannot exceed the annual limits or you cannot contribute to a Roth IRA. Your inheritance does not count as income, so it does not affect your modified adjusted gross income. These limits depend on the filing status you use. For example, the income limits for married couples filing joint returns are the highest, followed by single returns. If you are married filing separately, the limits are very low. You can find the newly update limits in the annual version of IRS Publication 590.
Inherited Roth IRAs
If your inheritance includes a Roth IRA, you can roll over the money from the inherited account to a Roth IRA in your name only if the decedent was your spouse. If the decedent wasn't your spouse, you cannot combine the inherited Roth IRA with the Roth IRAs you have in your name. Instead, you must either take annual distributions every year or empty the IRA by the conclusion of the fifth year after the decedent died. Otherwise, you'll face income tax penalties.
Contribution Limits Still Apply
Even if you can contribute to a Roth IRA for the year and you plan to use inherited funds to do so, you still can't contribute more than the annual limits. As of 2012, you couldn't contribute more than $5,000 ($6,000 for folks 50 and older) to a Roth IRA. These limits are per person. For example, if you are married, both you and your spouse are younger than 50 and you are otherwise eligible to contribute to a Roth IRA, you can contribute up to $5,000 to your Roth IRA, and your spouse can contribute up to $5,000 to her Roth IRA.
However, you have to decrease that limit by each dollar that you contribute to a traditional IRA. For example, if you put $1,000 into a traditional IRA and you're in your thirties, you can contribute a maximum of only $4,000 to a Roth IRA.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."