Inheriting a Roth IRA
Many people are surprised to learn that if you inherit a Roth IRA from anyone other than your spouse, you need to withdraw required minimum distributions irrespective of how old you are.
Most people are familiar with RMDs required of traditional IRA owners over 70.5 years of age. In contrast to the traditional IRA, RMDs from Roth IRAs are not subject to income tax assuming they are qualified. "Qualified" means that the Roth has been around for five years or longer. (You'll find more information in IRS Publication 590 at www.irs.gov).
What does a non-spouse Roth IRA beneficiary need to know?
The best way to determine your options is to get your hands on the Roth IRA custodial agreement, which you can get from the custodian holding the Roth. That agreement governs what you can do; be warned that it may be more restrictive than what the law might permit.
For example, the quote below is from a major financial institution's Roth IRA agreement.
1. If the depositor dies before his or her entire interest is distributed to him or her and the depositor's surviving spouse is not the designated beneficiary, the remaining interest will be distributed in accordance with (a) below or, if elected or there is no designated beneficiary, in accordance with (b) below.
Let me interject here with a definition. "Designated beneficiary" is a term defined by the tax code. It's a person with a life that can be measured, as opposed to your "estate."
That means that if you name your "estate" as your beneficiary or if you forget to name a beneficiary, (b) will apply (we'll come back to (a)):
" (b) The remaining interest will be distributed by the end of the calendar year containing the fifth anniversary of the depositor's death."
Let's stop there for a minute. If (b) applies, that's a disadvantage to all, since the Roth terminates five years after the owner dies.
Now let's look at (a):
"(a) The remaining interest will be distributed, starting by the end of the calendar year following the year of the depositor's death, over the designated beneficiary's remaining life expectancy as determined in the year following the death of the depositor."
Under (a), which is known as a "stretch IRA," the Roth continues for the life expectancy of the designated beneficiary. You can look up life expectancy in the single life table for use by beneficiaries in IRS Publication 590, Appendix C -- Table 1 is on page 86 of the 2011 publication.
Here is an example of how the formula works, quoting from the Roth IRA Answer Book (Sixth Edition) by Lesser, Appleby and Kolojeski (Aspen Publishers).
"Joe names his son Jeff as beneficiary of his Roth IRA. Joe dies in August of 2011. As of Dec. 31, 2011, the Roth IRA balance is $400,000. Jeff's attained age in 2012 is 56. Referencing the Single Life Table, Jeff determines that his distribution multiple is 28.7. Therefore, Jeff must withdraw $13,937.28 ($400,000 ÷ 28.7) in 2012. For each subsequent year, the 2012 factor is reduced by one (i.e., 2013 = 27.7, 2014 = 26.7, etc.)."
Stretches are highly beneficial, especially if you have a young beneficiary, for good reason: The Roth is invested in a tax-free environment. The longer you hold onto it, the longer it can grow tax-free. Once withdrawals are made, that money is in a taxable environment.
Importantly, for the stretch to work, the beneficiary must start on time -- no later than Dec. 31 of the year following the year of the owner's death.
If they don't start on time, you may be stuck with the five year rule. No penalties will be due for failure to withdraw the first through fourth year, as long as all is withdrawn by the fifth year.
If you decide that you made a mistake and would really want to do a stretch, it is possible to work with your accountant or tax lawyer to pursue that route. You can argue that you failed to take your first stretch RMD and will pay the penalty for doing so. That penalty is 50 percent of the amount that should have been withdrawn but was not. You'll need to research this option. A good resource is CCH's subscription service called Intelliconnect (www.intelliconnect.cch.com).
What about a spouse beneficiary? Is he or she subject to Roth IRA RMDs? Surprisingly, the answer is "yes"; however, the survivor has the option of treating the Roth IRA as his or her own. That means that the surviving spouse will not need to take RMDs during his or her lifetime.
If the survivor does not choose to a spousal rollover, he or she must begin RMDs on or before the later of:
1. Dec. 31 of the year following the calendar year in which the Roth IRA owner died, or;
2. The end of the calendar year in which the Roth IRA owner would have attained age 70½.
Here are two examples from the Answer Book:
"Devon dies on April 20, 2010, after naming his wife, Lydia, as beneficiary of his Roth IRA. Lydia does not perform a spousal rollover. Devon was age 52 at the time of his death. Lydia may wait until Devon would have turned age 70½ (i.e., 2028) to begin taking RMDs."
"Donald dies on May 1, 2010, after naming his wife, Lilac, as beneficiary of his Roth IRA. Lilac does not perform a spousal rollover. Donald was age 72 at the time of his death. Because Donald was already age 70½, Lilac must begin taking RMDs by Dec. 31, 2011."
As a reminder from last week's column, it is critical that designated beneficiaries title inherited IRAs properly in order to ensure the stretch option and avoid penalties.
Quoting from the Roth IRA Answer Book:
In addition, if you inherit an IRA, don't forget to name your own beneficiary to allow your heirs to enjoy the stretch option should you die before the Roth is depleted.
Julie Jason, JD, LLM, award-winning author of "The AARP Retirement Survival Guide: How to Make Smart Financial Decisions in Good Times and Bad," is principal of Jackson, Grant Investment Advisers, Inc. of Stamford. Please e-mail her with questions at firstname.lastname@example.org or write to her c/o The Advocate, 9A Riverbend Drive South, Box 4910, Stamford, CT 06907. Copyright 2012 Julie Jason.