The Advantages of an Inherited Roth IRA

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

• Tax advantages
• Lifelong growth opportunity
• Probate avoidance

This article will discuss how this type of IRA works and why you may want to include a Roth IRA in your estate planning.

Roth IRAs: The Basics

There are a couple of terms and basic elements you should know about contributions, withdrawals, eligibility, inheritance, and more.

Eligibility

In 2022, anyone earning less than $144,000 individually (modified adjusted gross income (MAGI)), or earning less than $214,000 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 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 for people to contribute to a Roth IRA, as long as the money being contributed comes from earned income from work. A non-working spouse can also contribute to a Roth IRA if they have a spouse who is earning income.

The more money you make above a certain IRS-identified amount ($129,000 or $204,000 in 2022), the fewer dollars per year you are allowed to contribute to a Roth IRA.

Withdrawals

Unlike other IRAs, there are no required minimum distributions (RMDs) with a Roth IRA.

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). One of the changes this law made is who could access the lifetime benefit of the Roth IRA. (The lifetime benefit is that one does not need to take an IRA distribution out of the account but can let it accumulate.)

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 IRAbeneficiaries must distribute all the assets in the account within 10 years of the original owner's death.

Five-Year Rule

Roth IRAs have a “five-year rule" on certain types of account withdrawals. If you fail to follow the five-year rule, you could wind up paying 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 penalty, if your Roth IRA has been open for at least five tax years.
• If you converted a traditional IRA to a Roth, the 5-year period starts on January 1 of the year you make the conversion or inheritance.
• If you inherit a Roth IRA that is at least five years old, you can withdraw all of the money tax-free as a lump-sum distribution. If you are eligible, you can also choose to 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 later when it hopefully meets the five-year rule. That way you can avoid paying taxes on the earnings (not contribution) part of the account. Just be sure all of the money has been taken 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 at any time without suffering any tax penalties. However, withdrawing earnings on those contributions will be taxed and you could face an early withdrawal penalty if you withdraw those earnings before you turn 59-1/2.

Contributions to a Roth IRA account are not tax-deductible. This may seem like a raw deal, but it's really not. Unlike other retirement accounts, when you withdraw money from a Roth IRA it will not be taxed.

Think of a single dollar contribution. Under a Roth IRA, you owe taxes on that $1 upfront. Years down the road, when that dollar has grown into $10, tax-free. The advantage is further compounded if the account holder is in a higher tax bracket when they are older, making the savings even more dramatic.

Advantages of a Roth IRA: Lifelong Growth

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

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 make a withdrawal from a Roth IRA account ever. They can simply 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. Simply request a beneficiary form from the account custodian, and name whomever you want as beneficiaries of the account. The account does not need to be named in a will or trust; the beneficiary form itself is sufficient.

Upon your death, the beneficiaries will 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 death of the account holder. A Roth IRA also has a named beneficiary who can inherit the account.

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.