All About IRAs

The Roth IRA Part V: Beneficiaries, Etc.

All About IRAs
Related Links

By Roy Lewis

We've discussed many of the common issues that you will be faced with when dealing with the Roth IRA. As our discussion of the Roth IRA winds down, let's turn to some other issues that may be of interest.

Not Subject to Minimum Distribution Rules

Unlike a traditional IRA, a Roth IRA is not subject to the minimum distribution rules. This means that you will not be required to remove any of your Roth IRA funds in the year in which you turn age 70 1/2. This being the case, a Roth IRA will allow you to continue to build up the value of the IRA free from all income taxes for the benefit of your heirs. And while estate taxes may have to be paid on the value of the Roth IRA upon your death, no part of the Roth IRA will be subject to income tax to your beneficiaries. This is completely different from a traditional IRA. The value of a traditional IRA will be included in your estate. But the traditional IRA earnings will also be taxed as income to your beneficiaries. This could cause a very large combined estate/income tax to be assessed against your traditional IRA. A Roth IRA can eliminate much of this tax burden because Roth earnings are not subject to income tax, either to you or to your heirs. This could be an enormous estate tax issue for many of you, and something that you should understand and implement into your estate tax planning.

Spouse as Roth IRA Beneficiary

As with a traditional IRA, if your spouse is your Roth IRA beneficiary, and you happen to go to the great beyond, your spouse can treat your Roth IRA as her own. She can keep the Roth IRA intact. She will not have to "accelerate" or even take income should you pass on. Your spouse will also not have to deal with any required distribution rules, and will have all of the normal rights and privileges that would accrue to any Roth IRA account. Short and sweet.

Non-Spouse as Roth IRA Beneficiary

If you decide to have a non-spouse as your Roth IRA beneficiary, your rules will be a little different. When the beneficiary is not a spouse, that beneficiary must take the Roth IRA distributions:

  1. By the end of the year containing the fifth anniversary of the account owner's death; or
  2. Over the life expectancy of the beneficiary, starting no later than Dec. 31 of the year following the year that the account owner died.

But this isn't necessarily a bad thing. Think about it. Any distribution in the year that includes the fifth anniversary of the owner's death would have to be made after the five-tax-year period restrictions on contributions/conversions had expired. Therefore, no part of the distribution would be included in the beneficiary's income. So while the account must be eventually liquidated by the beneficiary, Uncle Sammy has allowed for a method by which, if the beneficiary does the right thing, none of the Roth IRA proceeds will be subject to tax or penalty. Of course, if the beneficiary is greedy and wants to take the Roth IRA distribution immediately after the death of the Roth IRA owner and before five tax-years have passed, there may be taxes to pay. So, in this case, patience is rewarded in the form of tax-free income.

On the other hand, if distributions are made over the life expectancy of the beneficiary starting no later than Dec. 31 of the year following the year in which the owner died, it is very possible that some of those distributions would be included in the beneficiary's income. Why? Because the five-tax-year holding period may not have been met. But since distributions are treated as being made out of contributions first, the chances are that most distributions made before the end of the five-tax-year period would be made out of contributions, and would not be subject to tax.

But regardless of how the beneficiary decides to take the Roth IRA distributions, and regardless of the taxability of the distributions (if any), none of the distributions would be subject to the 10% early withdrawal penalty. If you go back and read the article on Roth IRA penalties, you'll find that the death of the Roth IRA holder will avoid the 10% penalty on the beneficiary.

Example

Shirley converts her traditional IRA to a Roth IRA in 1998. Her conversion tax amounted to $15,000. Shirley included all of this conversion income in her 1998 income, and reported that income in full on her 1998 tax return. Shirley also made $2,000 Roth IRA contributions for 1998 and 1999.

In 2002, Shirley passes away. Her Roth IRA beneficiary is her daughter LaVerne. LaVerne can take the entire Roth IRA distribution immediately, but will be subject to some taxes (because she will have taken the distribution before the five-tax-year holding period had expired on the original conversion). But even if LaVerne has taxes to pay on the Roth IRA distribution, there will be no penalties imposed.

According to the rules, LaVerne can wait as long as "the end of the year containing the fifth anniversary of the account owner's death" to remove the funds. Since Shirley died in 2002, Laverne must remove the funds from the Roth IRA account no later than Dec. 31, 2007. The five-tax-year holding period would be met in year 2003. So if LaVerne waits until sometime in year 2003 to take the distribution, none of the Roth IRA funds would be included in LaVerne's income. Why? Because the five-tax-year holding period was met, and the account assets were distributed before the required distribution date (Dec. 31, 2007).

So, as you can see, even though a non-spouse beneficiary is much more restricted with respect to the inherited Roth IRA account than a spousal beneficiary is, the rules are flexible enough to allow for the beneficiary to dodge taxes and penalties.

Next up, check out our Top Ten IRA Questions, taken from our discussion boards.

Next: The Top 10 Roth IRA Questions »« Previous