The Advantages of an Inherited Roth IRA

A Roth IRA is an Individual Retirement Account that allows you to contribute after-tax dollars. Roth IRAs are popular vehicles for retirement savings for several reasons.

A Roth IRA allows your retirement savings to grow tax-free. Roth IRAs are tax-friendly to the account holder. The account holder doesn't pay taxes on distributions during retirement. An inherited Roth IRA is also tax-friendly to beneficiaries who inherit a Roth IRA.

There are two primary advantages for the recipient of an inherited Roth IRA:

• Lifelong growth opportunity: if you don't need the money, the account can continue to grow tax-free until your heirs receive the funds
• Probate avoidance: with properly designated beneficiaries, your Roth IRA will not be included as part of your estate in a probate process

Roth IRAs: The Basics

You should know a few terms and basic elements about contributions, withdrawals, eligibility, inheritance, etc. This information will allow you to make informed decisions about this asset as a part of your overall estate plan.

Eligibility

In 2023, anyone earning a modified adjusted gross income (MAGI) less than $153,000 individually or $228,000 jointly as a couple can open their own Roth IRA. Higher earners cannot open or contribute to a Roth IRA. This taxable income level changes every year, so check the IRA rules to see if you can create a Roth IRA.

Contributions

The contribution limit, or the amount you can contribute to a Roth IRA, is controlled by age. People over 50 are allowed to contribute more than people under 50. There is no age limit to contribute to a Roth IRA as long as the contributed funds come from earned income from work. A non-working spouse can also contribute to a Roth IRA if they have an income-earning spouse.

The more money you make above a certain IRS-identified amount, the fewer dollars per year you can contribute to a Roth IRA. The IRS-identified amount in 2023 is $138,000 for individuals or $218,000 for married couples filing jointly.

Withdrawals

Unlike other IRAs, there are no required minimum distributions (RMDs) for the owner of a Roth IRA. Although beneficiaries of a Roth IRA are subject to the RMD rules relating to IRA distributions.

Inheritance

The rules for inheriting a Roth IRA have changed since the passage of the SECURE Act in 2019 (Setting Every Community Up for Retirement Enhancement). This law changed who could access the lifetime benefit of the Roth IRA.

After the Secure Act, only the following beneficiaries of an inherited Roth IRA can stretch it to take distributions based on their own life expectancy rate:

• A surviving spouse
• Minor children
• Beneficiaries who are disabled or chronically ill
• Beneficiaries who are not more than 10 years younger than the decedent

All other Roth IRA beneficiaries must comply with the 10-year rule. The 10-year rule requires the distribution of all assets in the account within the 10-year period of the original owner's death.

Five-Year Rule

Roth IRAs have a “five-year rule" on certain account withdrawals. If you fail to follow the five-year rule, you could trigger tax consequences that could impact your tax bill. These may include incurring income tax on earnings withdrawals and a penalty.

The clock starts ticking on January 1 of the year you made your first Roth IRA contribution. You can withdraw during these circumstances:

• At age 59½, you can withdraw contributions and earnings with no early withdrawal penalty if your Roth IRA has been open for at least five tax years.
• If you completed a Roth IRA conversion from a traditional IRA, the 5-year period starts on January 1 of the year you make the conversion or inheritance.

If you inherit a Roth IRA at least five years old, you can withdraw all the money tax-free as a lump-sum distribution. If you are eligible, you can stretch out payments over five years by taking the required minimum distributions. This option is helpful if the Roth IRA has not been in place for five years. Distribution rules determine that “contributions" are paid out first. This makes it possible to leave the “earnings" portion in the account until it meets the five-year rule. You can avoid tax consequences. You will avoid paying taxes on the account's earnings. Just be sure you have taken all of the money out of the account by December 31 of the fifth year, or you could face a 50% penalty on that remaining amount.

The five-year rule doesn't apply if you are withdrawing up to $10,000 in earnings to pay for a first home, higher education, health insurance premiums if you are unemployed, or medical expenses that exceed 10% of your adjusted gross income. If you have any questions, be sure to talk to an estate planning attorney or tax advisor before you make a withdrawal.

Advantages of a Roth IRA: Tax Advantages

The account owner can withdraw their after-tax contributions without tax penalties. However, you will face an early withdrawal penalty if you withdraw those earnings before you turn 59½.

Contributions to a Roth IRA account are not tax-deductible. This may seem like a raw deal, but it's not. You already paid income taxes on the money used for Roth IRA contributions. Unlike tax-deferred retirement accounts, where the growth is not taxed until retirement, funds withdrawn from a Roth IRA are not taxed when withdrawn.

Think of a single-dollar contribution. Under a Roth IRA, you owe taxes on that $1 upfront. Years later, that dollar has grown to $10, tax-free. If the account holder is in a tax bracket with a higher tax rate when they are older, the advantages of a Roth IRA further compound.

Advantages of a Roth IRA: Lifelong Growth

There is no need for the original account owner to ever make a withdrawal from a Roth IRA account. Due to this “lifetime benefit," a Roth IRA can become an inheritance for family members, making it a powerful estate planning tool.

Traditional IRAs have required distributions. The account holders must begin withdrawing from the account at age 70-1/2, whether they need to or not.

Roth IRA owners, on the other hand, have relaxed RMD rules. There is no need for the original account owner to ever make a withdrawal from a Roth IRA account. They can let the money grow, increasing the value of the Roth IRA that their eligible designated beneficiary can inherit.

Creating beneficiaries for your Roth IRA is remarkably easy. You must complete beneficiary designations for your Roth IRA by requesting a beneficiary form from the account custodian. You can name whomever you want as account beneficiaries, including a non-spouse, loved ones, or anyone else you include on the beneficiary designation form.

With a properly completed beneficiary designation, the Roth IRA does not become part of your estate included in any probate process. Thus, you do not need to include your Roth IRA in your will or trust. In fact, the beneficiary designations take precedence over any stipulation in your will. The beneficiaries typically only need a copy of your death certificate and personal identification to claim the money in the account.

Advantages of a Roth IRA: Probate Avoidance

Traditional retirement accounts avoid probate by assigning a beneficiary for the account upon the account holder's death. A Roth IRA also has a named beneficiary who can inherit the account. Be sure to keep the beneficiary designations on your Roth IRA (and other financial accounts) up to date. This will ensure the money will go where you want it to without delay.

Considering a Roth IRA? Talk to an Estate Planning Attorney

Before you decide on the type of IRA (or IRAs) you want, talk to your financial advisor, tax advisor, or the estate planning attorney helping you with your retirement accounts. Your advisor will review your personal finances to see if a Roth IRA fits with your estate planning goals and retirement plan.