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Retirement Perspectives

Individuals should be aware of the rules for required minimum distributions and other choices when inheriting a Roth account.

As described in my recent columns (read them here and here), Roth accounts offer a variety of benefits. The primary advantage of Roth is the tax-free accumulation of savings. Notably, these benefits extend to Roth beneficiaries. Therefore, Roth accounts serve as a tremendous estate-planning tool, providing potential tax-free payouts to heirs over the course of their lifetimes.

What happens when an individual inherits a Roth account? While Roth contribution rules are relatively straightforward, inheriting a Roth offers a maze of options. Much of the interest, if not outright confusion, is the choices that are available when a non-spouse or trust beneficiary inherits a Roth account. One key point to know is Roth IRA beneficiaries have the same after-death “stretch” opportunity as  inheriting a traditional IRA. The only difference is that required minimum distributions (RMDs) from an inherited Roth IRA will generally (but not always) be tax free, whereas distribution from an inherited traditional IRA will be subject to taxes.

Required Minimum Distributions
Let’s review the rules for RMDs. As you’re aware Roth IRAs are not subject to required minimum distributions (RMDs) during the account owner’s lifetime. However, designated Roth 401(k) accounts—officially referred to as Designated Roth Accounts (DRAs) are subject to lifetime minimum distributions. Further, some, but not all, beneficiaries are subject to minimum distributions. A missed RMD is subject to a 50% penalty tax on the amount should have been distributed but wasn’t. Picture this: Paying a 50% penalty tax on a distribution that would most likely have been tax free. Painful!

The biggest challenge  with Roth minimum distribution rules is that beneficiaries and participants, in the case of designated Roth accounts, are generally unaware of their requirement to take such distributions. Therefore, the individual’s financial advisor (or CPA accountant or attorney) needs to make sure a non-spouse beneficiary takes minimum distributions after the death of the owner—otherwise, he/she would potentially be subject to a 50% penalty tax.

Designated Roth Accounts (401(k), 403(b), governmental 457(b), TSP)
Roth accounts owned inside an employer plan are known as Designated Roth Accounts and are subject to lifetime RMDs. DRAs generally follow RMD rules applicable to traditional pretax accounts. Therefore, in general, DRAs will be subject to RMDs upon the participant turning 70½. However, if the participant is still employed (by the employer sponsoring the plan) and is not more than a 5% owner, the “still-working exception”  may apply, thus his/her Roth funds would not be subject to RMDs—just as pretax dollars. Notably, the plan document must specifically allow for the delay of RMDs through the “still working” exception. Check the summary plan description (SPD) to make this determination.

Tip: There is a way to avoid DRA RMDs! Here’s how. Roll DRAs to a Roth IRA in the year the owner reaches age 69½ or earlier. By doing this, RMDs have been avoided for the account owners life! If the owner delays the rollover until age 70½ or after, a rollover (to a Roth IRA) is still permissible. However an additional step is needed: the owner must first take an RMD from the DRA prior to the rollover. In other words, the owner is eligible to rollover any amounts above the amount of the RMD.

When are inherited Roth accounts subject to minimum distributions?
When a Roth IRA owner dies, the account belongs to the beneficiary. How much control the beneficiary has over the inherited Roth account depends on the status of the inheritor. In general, beneficiaries who inherit a Roth account from their spouses have significantly more options and flexibility available, thus allowing the account to continue to accrue tax-free, whereas non-spousal payout rules are more rigid.

Bequeathing a Roth IRA can be more appealing than receiving a tax-free inheritance. Why? The “stretch” payout allows distributions to be stretched out over the life expectancy of the beneficiary. Therefore, the entire account plus any future earnings are distributed tax free regardless of the investment. Further, Roth distributions, due to their tax free nature, do not impact tax deductions, tax, credits, and other means-tested benefits. Therefore, I believe it’s crucial to be familiar with Roth inheritance rules and strategies

As mentioned earlier, owner of Roth IRAs are not subject to RMDs—ever. However, their heirs—other than a surviving spouse—must take RMDs from an inherited Roth IRA. Notably, post-death RMDs from non-spouse inherited Roth accounts are calculated in the same manner as post-death RMDs for inherited traditional IRAs. The one enormous difference: distributions from inherited Roths are generally (but not always) tax free.

There are two options for a non-spouse inheriting a Roth IRA:

1. Five-year Rule. Here, the beneficiary must liquidate the entire value of the inherited IRA by December 31 of the year containing the fifth anniversary of the owner’s death. Notably, no RMDs are required during the five-year period. For example, Bart dies in 2019, leaving his Roth IRA to his son Tony. If Tony opts for the five-year payout, he must distribute all assets by December 31, 2024.

2. Life expectancy payout commonly referred to as “stretch.” Here, the funds will be distributed to the non-spouse beneficiary over their life expectancy based on his/her age starting the year after the owner’s death. If distributions (to the beneficiary) do not commence by December 31st following the year of the owner’s death, the rule requiring a complete distribution of the plan balance within five years may become effective. In other words, the tax free “stretch” payout will be five years, at most.

Tip: The “stretch” can, if implemented properly, last multiple lifetimes. If a beneficiary dies before the end of their stretch payout, the payments could continue to their named beneficiary (referred to as a successor beneficiary). It’s wise for an individual that inherits a Roth IRA to immediately name their primary beneficiary, thus allowing the “stretch” to continue upon the death of the first (original) beneficiary.

A third option—available only to spousal beneficiaries—is to make the Roth IRA his/her own and never be subject to RMD, thus resulting in additional tax-free account accumulation of savings during the surviving spouse’s lifetime.

Contrary to popular belief, distributions from an inherited Roth IRA are not always tax free. Roth IRA contributions are not tax-deductible, so if you’ve inherited a Roth IRA, all of the contributions can be withdrawn tax free. Further, if the account owner at the time of their death held any of their Roth IRAs for five years all assets (including earnings) from the inherited Roth will be distributed (to the beneficiary) tax and penalty free. It’s that simple. However, upon death of the account owner if he/she did not have the account open for five years, any growth (earnings) will be subject to income taxes, although basis (e.g. contributions and conversions) will be distributed tax and penalty free.

Tip: Roth IRAs follow distribution “ordering” rules—earnings, which are the last funds paid out (after contributions and conversion dollars) would be taxablebut not subject to penalty—if withdrawn within five years of the first Roth IRA contribution/conversion.

For example, Sam dies in 2019, leaving her Roth IRA valued at $100,000 to Tanya, her daughter. Sam has held the Roth IRA for more than five years as it was established in 2007. Tanya must begin taking minimum distributions no later than year following Sam’s death (December 31 2020). However, all distributions (including earnings) will be free of taxes! Why? Sam, the original account owner satisfied the five-year holding period.

Here is a second example. Roger dies in 2019, leaving his Roth IRA valued at $100,000 to his son Matthew. Roger did not satisfy the five-year hold period, as he established his first and only Roth via an $80,000 conversion in 2017. Matthew opts take a 100% full distribution. Matthew will be subject to income tax on the growth ($20,000). Notably, Matthew can distribute $80,000 of basis tax free immediately. The remaining $20,000 can first be distributed tax free on January 1, 2022 (the earliest the five-year hold period will be satisfied).

Can a beneficiary convert an inherited IRA to a Roth IRA?
Yes and no. A surviving spouse can always move the funds inherited from the deceased spouse to his or her own traditional IRA and then do a conversion to a Roth IRA. The options are more limited when a non-spouse beneficiary inherits a traditional IRA—here they are married to the inherited traditional IRA for life. There is no provision that permits a non-spouse beneficiary to convert an inherited IRA (traditional, SEP, SIMPLE) to an inherited Roth IRA.

A non-spouse beneficiary of an employer plan account (i.e. 401(k)) does have the option to convert, although the assets must be directly sent to an inherited Roth IRA. In other words, an inherited employer plan account can be converted to an inherited Roth IRA, but an inherited IRA can’t.

For example, George dies, and leaves his 401(k) with $100,000 to his son, Tommy. Tommy can do a direct rollover to an inherited traditional IRA or convert the any portion of the account directly to an inherited Roth IRA. But the amount converted would be subject to income taxes and must be paid by the beneficiary doing the conversion.

Tip: Take caution! If George first moved the money into an inherited traditional IRA today, and later decided he wanted to convert to an inherited  Roth IRA (even as soon as the next day) he is out of luck. He is “stuck” with the inherited traditional IRA.   

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

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