Rarely do people time their deaths to perfectly align with the end of their retirement accounts. If you inherit an IRA when a loved one dies, converting it to a Roth IRA means you can take tax-free qualified distributions. You can convert it as a rollover or a transfer, but there is one important stipulation you must meet before you can make either move.
You can convert an inherited IRA to a Roth IRA via rollover or transfer, but only if the person was your spouse.
Spouses Only for IRA Conversion
Though death did part you and your spouse, the benefits of your marriage continue to live on in one financial way. Only an IRA inherited from your former spouse can be converted to a Roth IRA. IRAs inherited from anyone else can't be converted. Any IRA passed on to you from a spouse becomes yours to keep or convert as you please.
Converting Via Rollover
Converting with a rollover isn't hard to do, but there is a catch. Once you take a distribution from the inherited IRA, you have 60 days to redeposit the money in a Roth IRA. The major hitch is you get 80 percent of the money you request, and Uncle Sam holds the rest until your file your tax return.
If you don't put 100 percent of the amount requested into the Roth IRA, any amount not converted gets treated as a distribution. For example, if you want to roll over $100,000 to a Roth IRA, you get $80,000, but you'd have to come up with the remaining $20,000 from elsewhere. Yes, when you file your income tax return you get that $20,000 back, but by then it's too late to finish the rollover.
Converting Via Transfer
The better option is a transfer, where the bank moves the money straight from the inherited IRA to a Roth IRA without you ever having to touch it. Since it never gets paid to you, you don't have to worry about the withholding. In addition, you don't even have to fret about forgetting to put the money into the Roth IRA before the 60-day deadline.
Tax Reporting for IRAs
The amount you convert from the inherited IRA to a Roth counts as taxable income. This makes such a conversion a good idea when you're in a lower income tax bracket as opposed to the future when distributions push you into a higher bracket. However, if you've got a large amount of other income in the year of your former spouse's death, you might be better off waiting a year or two until you're in a lower tax bracket. On the bright side, when you take distributions, they come out tax-free.
Contributions from Distributions
Even if the deceased wasn't your spouse, you might still be able to move some of the money to a Roth IRA each year, just not through a rollover or transfer. If you have other compensation, and your taxable income isn't too high, you can make a contribution to a Roth IRA. You will be taxed on the distribution from the inherited IRA, but you would have been taxed on the Roth IRA conversion anyway.
For example, if you have $40,000 in wages for the year and take out $5,000 from the inherited IRA, you can put that $5,000 into a Roth IRA if you haven't already made your IRA contribution for the year. The $5,000 distribution is taxable, and the contribution is permissible because it's your Roth IRA, and your income allows you to contribute.