Divider
Divider

Jennifer Sicking
Jennifer Sicking
Non-Spousal Roth IRA Beneficiaries
The good, the bad and the ugly.

October 20, 2011
by Jennifer Sicking, CPA, PFS

Now that the income limitation is currently waived on conversions of traditional individual retirement accounts (IRAs) to Roth IRAs, higher earning taxpayers are eligible to convert their pretax retirement savings to Roth IRAs. This could potentially make Roth IRAs more popular than ever before, increasing the likelihood of clients inheriting a Roth IRA in the future. Practitioners should become well versed in advising clients on the mechanics of non-spouse Roth IRA beneficiary designations and the consequences for those who inherit the Roth IRA.

The Good

Potential Wealth Accumulation Tool
Roth IRAs do not have minimum distribution requirements during the account owner’s lifetime. This allows for more accumulation of wealth as more funds stay in the account and earnings are re-invested. They are a great tool to consider in estate planning, especially when the beneficiaries are grandchildren. Additionally, beneficiaries could potentially have an opportunity to continue the growth in the account upon inheritance if the Roth IRA is handled properly.

Choices
Non-spouse beneficiaries have two choices upon inheriting the Roth IRA:

  1. Take minimum distributions over the beneficiary’s single life expectancy or
  2. Liquidate the account within five years.

If the distributions are qualified, they will not owe tax under either option. Non-spouse beneficiaries cannot roll over the funds into their own Roth IRA.

Consider the Differences
Liquidating the account within five years limits the time period available for tax-free growth in the account. Taking minimum distributions over the lifetime of the non-spouse beneficiary could allow for more wealth accumulation. Hypothetically consider a 10-year old inheriting a Roth IRA. Using the beneficiary’s remaining life expectancy could allow the account to continue to grow tax free for around 70 years instead of five years. This potential tax-free growth makes families and planners celebrate. Of course, the beneficiary can take out more than what is required, just not less than what is required.

Primary Beneficiaries or Contingent Beneficiaries
If the primary beneficiary dies, the non-spouse contingent beneficiary could become the primary beneficiary. Additionally, the primary beneficiary has the option to disclaim the inherited Roth IRA. If a primary beneficiary chooses to disclaim, the inherited Roth IRA goes to any other primary beneficiaries or the contingent beneficiaries, if any. This could be a valuable financial planning move for the client:

  • Nine-Month Rule is Critical to Disclaimers

    To be valid, a disclaimer must be signed by the beneficiary and meet other requirements no later than nine months after the date of death of the Roth IRA owner. If it helps to remember this rule, think that it takes nine months to have a baby and it takes nine months to disclaim an inherited Roth IRA.
  • September 30th — Important Date to Remember

    September 30th following the year of the Roth IRA owner’s death is the last day to finalize the designated beneficiaries of the inherited Roth IRA.

Both dates are vital. For example, assume the owner dies on June 30th. A valid disclaimer must be made by March 31st of the following year, whereas September 30th of the following year is the last day to finalize the designated beneficiaries.

Multiple Individual Beneficiaries Are Allowed, RMD Amount Could Vary
Determining the amount to be distributed as a required minimum distribution (RMD) can be tricky if there are multiple individual beneficiaries. If all beneficiaries are not individuals, the rules become even more complicated. Unfortunately coverage of those issues is outside the scope of this article due to space restraints.

If all are individuals and the account has not been separated for each beneficiary, the life expectancy calculation is made on the beneficiary with the shortest life expectancy. This could be a disadvantage to the younger beneficiaries and separate accounts would yield better tax savings. For example, there could be two beneficiaries aged 50 and 10. If the account is combined, the RMDs would be calculated over the lifetime of the 50-year-old, which would yield larger RMD amounts. If the 10-year-old would have had a separate account, the RMD amount would be substantially smaller and the tax free accumulation considerably longer.

If separate accounts are set up, which can happen at any time, then the separate accounts are calculated individually based on the beneficiary’s actual life expectancy. The rules provide a due date of December 31st following the year of the owner’s death to separate the Inherited Roth IRA account. Keep in mind, however, that September 30th is the date to finalize designated beneficiaries, so your clients should separate the accounts by the earlier September 30th due date instead.

The Bad

Timing Is Essential
Minimum distributions must begin before the end of the calendar year following the year of death. If they are not, the only choice available for distribution is the five-year rule. Distributions from another Roth IRA cannot be substituted for these distributions unless the other Roth IRA was inherited from the same decedent.

Titling Is Imperative
While the Pension Protection Act of 2006 did grant more flexibility in rollovers of some types of inherited retirement plans into the beneficiary’s own IRA, it did not allow non-spouse beneficiaries to roll over inherited Roth IRA funds into the beneficiary’s own Roth IRA account. It is important that the inherited Roth IRA identify the account as an “inherited Roth IRA” and also identify the deceased account owner and the beneficiary in the title.

The Ugly

Tax Penalty
If post-death distributions are not taken via the life-expectancy method or the five-year rule, a 50-percent penalty tax is assessed on the amounts that should be distributed. OUCH. Clients must be advised of this potential long before the event so that clients understand the importance of timing and proper communication with their investment advisor and their tax preparer. Practitioners will find no joy in notifying clients after the fact when there are few options.

Conclusion

The rules for inherited Roth IRAs are extremely complicated depending on the situation and it is encouraged that you read the entire rules specific to your client’s situation. This is not an area that has one uniform answer and diving into your client’s facts and circumstances will be critical to proper planning.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Jennifer Sicking, CPA, PFS practices at Ken Hughes & Associates, PC in Flower Mound, Texas. Her practice includes tax return preparation with an emphasis on planning. She also provides business consulting for her clients, who are primarily involved in the health care industry.