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If you inherit a Roth IRA from a parent and handle it correctly, you’ll be able to enjoy tax-free withdrawals for years to come. Your options will depend on which of two beneficiary categories you fit into. Here are the decisions you’ll need to make.
Key Takeaways
- Anyone who inherits a Roth IRA from a parent will eventually have to withdraw all the money from the account.
- In most cases, withdrawals will be tax free.
- The required timing for withdrawals depends on which category the person fits into: designated beneficiary or eligible designated beneficiary.
Your Roth IRA Options
The rules that beneficiaries who inherit a Roth IRA must follow differ depending on whether they are the deceased person’s spouse or not. If the IRA originally belonged to your parent, you fall into one of two categories: designated beneficiary or eligible designated beneficiary.
(Note that the SECURE Act of 2019 changed some of the rules on inherited IRAs. These are the current rules, which apply if your parent died after Dec. 31, 2019.)
What Is a Designated Beneficiary?
Designated beneficiary applies to most people who inherit an IRA from a parent. If you are one, you will be required to withdraw all the money from the account within the 10-year period following your parent’s death. However, exactly when you take out money—and how much you take out each time—is up to you. You do not have to take required minimum distributions (RMDs) every year, but can make withdrawals whenever you like, just as long as you deplete the account within that 10-year period. In the meantime, if you don’t need the money, you can enjoy another decade of tax-free growth. This is sometimes referred to as the “10-year rule.”
What Is an Eligible Designated Beneficiary?
The “eligible designated beneficiary” category applies to minor children (the age of majority varies by state), a surviving spouse, and individuals who are disabled or chronically ill. Minors can begin to take distributions over their remaining life expectancy, as determined by the tables in Publication 590-B of the Internal Revenue Service (IRS), until they reach the age of majority. After that they must follow the 10-year rule described above.
Anyone up to age 26 who has not yet completed a “specified course of education” may be considered a minor for this purpose, although the law is currently ambiguous on whether it applies to individual retirement accounts (IRAs) in the same way that it does to defined-benefit plans and annuities. The meaning of “specified course of education” is also less than precise. If you’re in this situation, it would be wise to consult an accountant or other tax pro who is well versed in this area before you proceed.
Others in the eligible designated beneficiary category can simply take distributions over their IRS-determined life expectancy.
These more flexible rules give eligible designated beneficiaries an opportunity to stretch their distributions over a longer time period and thus benefit from the Roth IRA’s tax-free compounding for that extended period. Eligible designated beneficiaries are not obligated to do that, however, and can take distributions as soon as they’d like, even right away in the form of a lump sum. As long as the account they inherited satisfies the five-year holding period rule, their distributions will be tax free.
The CARES Act waived RMDs for 2020, but that waiver has since expired and doesn’t apply for 2021 and thereafter.
Opening an Inherited IRA Account
If you are bequeathed an IRA—either Roth or traditional—by a parent, you will need to open an inherited IRA, which is sometimes called a “beneficiary IRA,” and move the money into it. You can do that at many financial institutions that handle regular IRAs. Unfortunately, you will not be able to contribute additional money to your inherited IRA.
How Inherited Roth IRAs Are Taxed
The money in an inherited Roth IRA will continue to grow tax free as long as it remains in the account. Distributions of the original account owner’s contributions aren’t taxed, and distributions of earnings are taxable only if the account doesn’t meet the five-year holding period rule. Inherited IRAs are not subject to the 10% penalty that is normally imposed on account holders who take distributions before age 59½.
How Does the IRS Define ‘Child’?
Under federal law a child is the son, daughter, stepson, stepdaughter, legally adopted child, or eligible foster child of the taxpayer.
Can an IRA Have More Than One Beneficiary?
Yes. When the original account owner dies, each beneficiary should set up their own inherited IRA with their share of the proceeds.
What Happens if I Don’t Take RMDs?
IRA account holders who don’t take RMDs on schedule can be subject to an excess accumulation penalty, which is a 50% tax on the difference between the amount they should have taken as a distribution and the amount (if any) they actually took. The IRS says it can waive all or part of the penalty if “you can show that any shortfall in the amount of distributions was due to reasonable error and you are taking reasonable steps to remedy the shortfall.”
The Bottom Line
Children who inherit a parent’s Roth IRA will eventually have to take all the money out of the account. The rules differ depending on whether they are classified as a designated beneficiary or an eligible designated beneficiary. Either way, if they handle the account properly, all of their distributions will be tax free. The rules on inheriting an IRA are unusually complex, even by IRS standards, so professional advice may be worth seeking, especially if a lot of money is involved.
