- Proper use of the 10-year rule with an inherited Roth IRA
- The distinction between EDBs and designated beneficiaries (DBs)
- Taxation on inherited Roth IRA distributions
Inherited Roth IRA
When exploring inheritance scenarios for Roth IRAs, a fundamental principle known as the “10-year rule” emerges as a critical pivot point. Before delving into the intricacies of various beneficiary options, a comprehensive understanding of this rule, as outlined by the Internal Revenue Service (IRS), lays the groundwork for informed decision-making.
The 10-year rule stipulates that beneficiaries who opt against life expectancy distributions from an inherited IRA must withdraw the entire balance by the end of the year containing the tenth anniversary of the original IRA account owner’s passing. However, this rule interacts distinctly with different beneficiary statuses, highlighting the significance of one’s designation in navigating the complexities of inherited IRAs.
This article meticulously elucidates the implications of being an eligible designated beneficiary (EDB), a designated beneficiary (DB), or a non-designated beneficiary, offering a comprehensive insight into the options and tax implications within each category. We also delve into the tax treatment of inherited IRA distributions, unraveling the nuanced facets of taxable and non-taxable distributions and contributing to a well-rounded comprehension of the overall landscape.
The 10-year Rule
Before we get into the various inheritance scenarios of Roth IRAs, let’s review the 10-year rule.
As the Internal Revenue Service (IRS) outlines, a significant regulatory framework governs the management of the inherited IRA. Particularly noteworthy is the mandate placed upon IRA beneficiaries who choose not to pursue life expectancy-based distributions from their inherited IRAs. Under this directive, beneficiaries must adhere to a timeline: the entire balance of the inherited IRA must be withdrawn by the tenth anniversary of the year of the original IRA account or the original owner’s passing.
This timeline is intended to underscore the IRS’s commitment to overseeing the appropriate utilization of inherited IRA assets but also serves as a mechanism to ensure the timely and equitable distribution of these assets among beneficiaries. By specifying this deadline, the IRS seeks to strike a balance between granting beneficiaries a reasonable window for accessing their inherited IRA funds and encouraging the timely realization of tax obligations associated with such distributions.
Eligible Designated Beneficiary Status
Inherited IRA Rules
First, you must determine if you are an eligible designated beneficiary (EDB) under IRS rules. You’ll qualify as an EDB if you are:
- The spouse of the deceased IRA owner
- A non-spouse beneficiary who is permanently disabled or chronically ill (as defined by the Internal Revenue Code, Sections 72(m)(7) and 7702B(c)(2), respectively)
- A non-spouse beneficiary who is not more than ten years younger than the deceased IRA owner
- A minor child of the deceased IRA owner
Some trusts may also be considered EDB, but not all of them.
If you qualify as an EDB, here are your options when the Roth IRA account owner passes away:
- You’re the spouse; you have several options: treat the IRA as your own, elect to receive single-life expectancy distributions, or follow the 10-year rule for inherited IRAs.
- A non-spouse beneficiary who meets the IRS requirements for permanent disability or chronic illness, or you are not more than ten years younger than the deceased IRA account owner, you may choose to receive single-life expectancy distributions or follow the 10-year rule.
- Minor child of the deceased IRA account owner, you may elect to receive single life expectancy distributions. But, as soon as they turn the age of majority, the account will be subject to the 10-year rule.
Age of Majority
The age of majority signifies the point at which an individual transitions into adulthood, recognized under the legal framework. This term draws its essence from the concept of “majority” within U.S. law, signifying the stage where adults are held accountable for the majority of their actions. This is in contrast to “minority,” denoting children who are only responsible for a minority of their efforts, with a parent or legal guardian assuming responsibility for most of their decisions.
Upon reaching the age of majority, individuals undergo a transformative shift in their legal status. While the age of majority is not universally determined by federal mandate, state governments wield the authority to establish this threshold, resulting in variations across states. Typically, the age of majority in the United States is either set at 18 or 21, symbolizing the threshold at which an individual is recognized as fully capable of bearing the responsibilities and obligations associated with adulthood.
The distinction arises between eligible designated beneficiaries (EDBs) and designated beneficiaries (DBs), each encapsulating a unique set of options and limitations. A designated beneficiary (DB) assumes this role when they are named as beneficiaries of the IRA but do not meet the qualifying criteria for eligible designated beneficiary status.
An illustrative example of a designated beneficiary could be an adult child of the IRA account upon the original owner’s death. In this scenario, while not meeting the criteria of a qualifying EDB, the adult child is still entitled to the inherited IRA as a designated beneficiary.
However, unlike their eligible designated counterparts, designated beneficiaries have a singular pathway to navigate. They are required to adhere to the guidelines stipulated by the 10-year rule. Under this rule, designated beneficiaries must withdraw the entire balance of the inherited IRA by the end of the tenth year following the original account owner’s passing, as mentioned above.
Inherited IRA Split Between Siblings
When adult siblings, having surpassed the local age of majority, become beneficiaries of an inherited IRA, they confront a choice presented in two distinct avenues. These siblings have the option of transferring the inherited IRA into an inherited IRA itself. This transfer can take shape through a single retirement account jointly owned by the siblings, fostering shared ownership. Alternatively, the siblings can distribute the inherited IRA into multiple accounts, each exclusively owned by a single sibling.
This essential rollover procedure is subject to a deadline of December 31 of the year, coinciding with the inheritance of the IRA. When the siblings opt for shared ownership through a single account, the ownership particulars can be determined through mutual agreement. Conversely, if they choose to distribute the inherited IRA into separate inherited IRAs without specific instructions, the siblings retain the prerogative to apportion the assets as they deem suitable, aligning with their respective circumstances and preferences.
A complementary aspect to the 10-year rule entails the option for the siblings to choose a lump sum withdrawal or Lump Sum distribution. They can collectively retrieve the entire inherited IRA value in cash and distribute the assets. This approach does not trigger any distinct penalties; however, it necessitates the payment of ordinary income taxes on the withdrawn amount, with the applicable top income tax rate determined by the siblings’ income level for the given year.
Notably, this action does not involve transferring funds into an inherited IRA. Instead, it involves a straightforward, complete withdrawal upfront. This approach operates in parallel with the 10-year rule by effectively fulfilling the fundamental stipulation that the complete value of the inherited IRA must be withdrawn and taxed within ten years following the year of death inheritance event.
While the name appears counterintuitive, this classification pertains to IRA beneficiaries lacking life expectancies. This group encompasses entities such as estates, charitable organizations, and specific trusts with multiple beneficiaries that do not meet the criteria for eligible designated beneficiaries (EDBs).
For a non-designated beneficiary of a Roth IRA, the requirement mandates the distribution of assets within five years following the demise of the original account owner.
Taxation on Inherited Roth IRA Distributions
The Roth IRA is an incredible retirement- and estate-planning vehicle we’ve discussed extensively on this blog.
If you inherit a Roth, you may wonder how taking distributions from it will affect your taxes. Here’s what you need to know.
- Distributions of the original amount contributed to the Roth are never taxable.
- Distribution of earnings on contributions to the Roth is not taxable as long as they happen at least five years after the deceased account holder deposited the first contribution to the Roth. For example, if the Roth IRA owner died this year and made their first contribution to the account in tax year 2019 (or earlier), the beneficiary will not be taxed on any distribution from the account – contributions OR earnings.
Taxation on Inherited Roth IRA Distributions Example
If an individual with a Roth IRA passed away in 2023 and initiated their initial Roth IRA account for the tax year 2018 or any prior year, the account becomes accessible for distribution to their beneficiary without incurring any tax obligations. This applies even if the original Roth IRA account was closed and transferred to another Roth IRA within the intervening period. Furthermore, if contributions for the tax year 2018 were made into the account before the April 15, 2019, deadline, they remain eligible for tax-free distribution.
However, if the deceased account holder established their first Roth IRA in the 2019 tax year or beyond, the distribution of earnings from the account becomes subject to taxation if it transpires before the completion of a whole five-year period from the account’s inception. This nuanced approach underscores the significance of the five-year timeline in determining the taxable nature of distributed earnings from Roth IRAs.
Inheriting an IRA demands a comprehensive grasp of the intricate web of rules and considerations that shape the future of these valuable assets. The “10-year rule” underpinning tenet establishes a fundamental framework, influencing the entire spectrum of beneficiary choices. Delving into the various scenarios, from eligible designated beneficiaries (EDBs) to designated beneficiaries (DBs) and beyond, exposes the interplay of options and limitations, each path offering distinct avenues for wealth preservation and distribution.
Inheritance, as witnessed in the realm of Roth IRAs, is far from a uniform path. The choices, responsibilities, and opportunities unveiled pave the way for beneficiaries to navigate the journey with a keen understanding of the rules and implications. Talk to a financial advisor today if you are unsure or want an expert opinion and advice for your financial future and inheritance.