In a perfect world, it may appear that we would want all of our money in a ROTH IRA. The reason is that savings and investments in a ROTH IRA grow tax free. However, in the real world there are rules, like the annual capping limitations for contributions or the tax dollars we may have to pay if we convert money from an IRA to a Roth IRA. Roths are a great way to save some of your retirement monies, but you need to understand the rules and the opportunities.
But what happens when someone inherits a ROTH IRA? The tax free growth aspect has come under the scrutiny of the IRS, especially as it applies to an inherited ROTH IRA. What this means is that ROTH IRA beneficiaries have important decisions to make regarding when and how they will withdraw monies from this tax free account.
The first option is to withdraw all the money within five years. If the account was established for at least five years with no conversions, then all of the money withdrawn is tax free. Withdrawals from accounts not open for five years will be taxed as ordinary income. If there were conversions, each conversion amount requires its own five year holding period. If the conversion did not meet the five year holding period, only the earnings associated from those conversion dollars will need to be calculated and reported as taxable income. Remember, monies withdrawn are considered to be from contributions first, conversions second, and earnings third. It is critical to understand this concept to reap all the rewards of continued tax free growth.
The second option is to withdraw a portion of the money over your life expectancy, leaving the bulk of the account to grow tax free. To enjoy this benefit, the new owner of the ROTH IRA must make sure they calculate the required minimum distribution amount every year and withdraw the funds by December 31st. The amount is calculated by dividing the previous December 31st balance by the beneficiaries’ single life expectancy. Every year thereafter, the divisor is reduced by 1. Many financial institutions do not track this amount, so it is up to the beneficiary to make sure this happens.
ROTH IRA beneficiaries need to become informed about their options. Obtaining the necessary know-how at the start of the inheritance is essential to maximize tax free growth for the new owner.