Inherited Roth IRA

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We sometimes see statements like this: "On your death, your beneficiaries receive your Roth IRA tax-free." That statement could be a little misleading. For one thing, the estate tax applies to assets you own in a Roth IRA the same way it applies to assets you own in a regular IRA. What's more, if you die less than five years after setting up a Roth IRA, your beneficiaries may have to pay tax on earnings if they withdraw them too soon.

Estate tax

The federal estate tax applies to assets you own at death if your taxable estate is more than the unused portion of your "unified credit amount." If you haven't used any of this amount by making taxable gifts, it is $2,000,000 for 2008 and $3,500,000 for 2009. Roth IRAs don't enjoy any special exemption from the estate tax. If you own a Roth IRA at death and it passes to someone other than your spouse, it will be included in your taxable estate.

There is one way Roth IRAs provide an estate tax benefit. Roth IRAs contain after-tax dollars. That means the size of your estate has been reduced by the amount of tax you paid on those dollars. The result is that you have a smaller taxable estate even though the value of what you're passing to your beneficiaries may be as great or greater than if you had a traditional IRA. That's why you may hear people say you receive estate tax savings from a Roth IRA. The estate tax savings come from the fact that you've already paid the income tax, not from any special estate tax rule that applies to Roth IRAs.

Income tax

The income tax treatment of a Roth IRA following death is the same as before death, with three exceptions:

• The 10% early distribution penalty generally does not apply to post-death distributions. (Note: it can apply to a spouse who elects to treat the Roth IRA as his or her own Roth IRA and subsequently takes a taxable distribution.)
• Beneficiaries can withdraw earnings tax-free, even if the beneficiary is under 59½ — but only if the five-year requirement is satisfied.
• Beneficiaries may be required to take distributions according to rules described below.

One rule that does not change is the requirement for the Roth IRA to exist at least five years before earnings can be withdrawn tax-free. To be more precise, earnings can be withdrawn tax-free beginning on the first day of the fifth taxable year after the year the Roth IRA was established. That means January 1, 2013 for Roth IRAs established in 2008.

As a result, a beneficiary may have to pay tax on earnings withdrawals if the original owner's death and the beneficiary's withdrawal both occur shortly after the Roth IRA is established. This result isn't as harsh as it may seem, however. The tax only applies to earnings that built up after the contribution to the Roth IRA. Normally that's a small portion of the Roth IRA if the withdrawal occurs such a short time after the original owner established the Roth IRA. What's more, a beneficiary can avoid this tax by leaving the earnings in the Roth IRA for the required amount of time — even if the beneficiary immediately withdraws everything except the earnings.

Example: In 2010 you inherit a Roth IRA that was established in 2008. The Roth IRA includes $96,000 from a rollover contribution and $4,000 of earnings. You can immediately withdraw the entire $100,000 and pay tax (but no penalty) on the $4,000 of earnings. Or you can withdraw up to $96,000 (paying no tax or penalty) and leave the $4,000 of earnings in the Roth IRA until 2013, when you can withdraw the balance of the Roth IRA tax-free.

Often the best choice for the beneficiary is to delay withdrawing money as long as possible, retaining the benefit of building tax-free earnings in the Roth IRA. In this case it will rarely be necessary to dip into earnings before satisfying the five-year requirement.

Non-spouse beneficiary

If you inherit a Roth IRA from someone other than your spouse, you aren't permitted to make contributions to the inherited IRA or combine it with any Roth IRA you established for yourself. What's more, you have to follow the minimum distribution rules for inherited IRAs.

The distribution rules that apply to an inherited Roth IRA are the same as the ones used for traditional IRAs in a situation where death occurs before the "required beginning date" for minimum distributions. This is true without regard to the age of the Roth IRA's owner at death, because there is no "required beginning date" for distributions from Roth IRAs.

For a beneficiary other than a spouse, distributions must satisfy one of the following rules:

• Rule 1: Receive the entire distribution by December 31 of the fifth year following the year of the owner's death.
• Rule 2: Receive the entire distribution over your life, or over a period not extending beyond your life.

The original owner may have specified which rule applies in the document used to set up the Roth IRA. More often, the choice is left to the beneficiary. If the choice is yours, you have to choose by December 31 of the year following the year the death occurred, because that's the last day to start receiving distributions under Rule 2.

Suppose you choose Rule 1. In this case you can delay your distribution, if necessary, until the fifth year after the year the IRA was established, to avoid paying tax on distributions of earnings. You can also withdraw all amounts other than earnings before that time without paying tax or penalty. When you reach January 1 of the fifth year after the year the original owner established the Roth IRA, you can withdraw the earnings as well without any tax or penalty.

If you choose Rule 2 instead, you may be required to take some distributions before the Roth IRA has existed five years. That's okay though, because you're not considered to have withdrawn any earnings until after you withdraw all the contributions (including conversion money). The required distributions under this rule are generally a small percentage of the overall value of the Roth IRA, so you aren't likely to take any distributions of earnings within five years unless you withdraw more than the required amount.

Spouse beneficiary

If you inherit a Roth IRA from your spouse you can elect to treat it as your own IRA. That means you can make regular or conversion contributions to this Roth IRA, assuming you are otherwise eligible to make such contributions to a Roth IRA of your own. Furthermore, the required distributions described above don't apply to a Roth IRA you elect to treat as your own. You can leave the money in the IRA as long as you want. Note, however, that if you elect to treat the Roth IRA you inherit from your spouse as your own IRA, you may not be able to withdraw earnings free of tax or penalty until you reach age 59½.