The ultimate goal of the Roth IRA is to qualify for non-taxable distributions. Spouse beneficiaries must take care to choose the option that leads to tax-free distribution.
Roth IRA rules
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The dilemma faced by spouse IRA beneficiaries is whether they should transfer amounts to beneficiary IRAs or to their IRAs. For inherited Roth IRAs, there are two key factors that determine which of these two is the better choice: (1) avoiding required minimum distributions (RMDs) i (2) non-taxable distributions. In an ideal world, the beneficiary of the spouse would receive both benefits. But in some cases one must be chosen.
Advantages that make the Roth IRA more attractive than the traditional IRA
There are two key benefits exclusive to the Roth IRA that make it more attractive than a traditional IRA.
1. There are no RMDs for owners, and
2. Qualified earnings distributions are non-taxable.
Not subjecting to RMDs means that the balance continues to grow with deferred taxes as long as the owner wants it. Also, accumulated earnings become tax-exempt if taken as a qualifying distribution.
Distribution is eligible if the following two requirements are met:
1. The owner has held a Roth IRA for at least five years, and
2. Distribution is made when the owner:
——A. He is at least 59 years old
——B. Is disabled, or
——C. Withdraws up to $ 10,000 for first home buyers.
When determining whether a Roth IRA owner meets the first requirement — a five-year retention period — all of their Roth IRAs add up. Therefore, a Roth IRA funded in 2020 would still meet the five-year requirement of 2020 if the owner funded another Roth IRA five or more years before 2020.
The distribution would also qualify if the owner held it for at least five years and died, and it is transferred to the Roth IRA beneficiary.
Options for the spouse user
A spouse who inherits a Roth IRA has two options.
A. Make a legacy Roth IRA by moving to your Roth IRA or not taking any user RMDs, or
B. Transfer to Roth IRA User.
The beneficiary of a spouse who has an inherited Roth IRA from the heir has the same benefits as the original owner – without RMD and non-taxable distributions when eligible.
Calculating a five-year period for the spouse’s beneficiary
If the spouse’s beneficiary treats the inherited Roth IRA as his own, the five-year period for the spouse and the testator is merged, and earlier than the two paragraphs.
For example: Had Jack founded the Roth IRA in 2014 and his wife Mary his 2020, Mary’s five-year period would have begun in 2014 if she inherited Jack’s Roth IRA and made it her own.
If a spouse transfers an inherited IRA to a Roth IRA beneficiary, the five-year period begins when the deceased first funded his or her Roth IRA.
For example: If the Team started the Roth IRA in 2018 and its beneficiary Susie inherited the IRA and transferred it to the Roth IRA beneficiary, the five-year period began in 2018.
Roth IRA and RMD users
As mentioned earlier, Roth IRA owners are not subject to RMD. This extends to the beneficiary spouse who makes the inherited Roth IRA his own.
However, if the spouse retains the amount in the Roth beneficiary’s IRA, they will be subject to health resource management requirements under one of the following options:
A. Ten-year rule: Under this option, distributions are optional until December 31 from 10th the year following the year in which the owner died.
B. Life expectancy rule: Under this option, the user must start taking RMDs over his or her life expectancy, starting later than:
a. December 31 of the year following the year in which the owner died, or
b. December 31, the year in which the owner would have turned 72 years old.
Failure to take the RMDs within the applicable deadlines would result in the beneficiary owing the IRS a 50% excess of the accumulation penalty on any shortfall in the RMD.
Which option is better? It depends
The fact that creating a legacy Roth IRA is your own seems like a better choice because it means there are no RMDs, which allows for flexibility in making the decision to take over the distribution. But a qualified distribution factor should also be considered. If a spouse’s beneficiary would be entitled to a qualified allocation for their own Roth IRAs — including deceased spouses if they move to their own — then moving to their own Roth IRA is an obvious choice.
However, if the five-year rule is followed, but distributions from their own Roth IRA would be subject to income tax because they are under 59 i and are not disabled or eligible for the first home buyer exception, moving it to a Roth IRA user would be better choice.
Example: Dick started the Roth IRA in 2014. The rest is $ 250,000, which consists of $ 20,000 in contributions, $ 80,000 converted from his traditional 2014 IRA, and $ 150,000 in earnings. His wife Sue is less than 59 years old and is not disabled.
Dick died in 2020. Sue revealed she had no choice but to withdraw a full $ 250,000 in 2021 to cover expenses. Suin’s choice would determine how taxable it would be.
If Sue makes the Roth IRA his own
The period of 5 years has been fulfilled. But Sue is not entitled to a qualified distribution because she is under 59 years of age and is not disabled. Therefore, $ 250,000 would be taxed as follows:
- $ 100,000 ($ 20,000 + $ 80,000) would be tax-free because it comes from amounts that have already been taxed by adding to Dick’s Roth IRA.
- $ 80,000 would not be subject to an additional 10% tax because it was converted more than five years ago.
- $ 150,000 would be taxable at her usual income tax rate. An additional tax of 10% would apply because it is under 59 ½ if it does not qualify for the exemption.
If Sue transfers an inherited Roth IRA to a Roth IRA beneficiary
The period of 5 years has been fulfilled. In addition, the distribution would be taken due to death and would therefore be a qualified distribution. As a result, as much as $ 250,000 would be non-taxable – neither ordinary income tax nor an additional 10% tax would apply.
Not all spouse beneficiaries are equal
In Sue’s case, choosing a Roth IRA user was a better choice. But it could have been different had it not planned for a full distribution in 2021. It would have been different for other spouse users whose user profile is not similar to Sue’s.
Before choosing, the beneficiary of the spouse should consult a tax professional who must take into account the following factors:
- Is the five-year rule met,
- Does the spouse’s beneficiary qualify for qualified distribution from his or her own IRA in relation to the Roth IRA’s beneficiary, and if not,
- Option that would result in a minimum tax amount, including an additional 10% tax avoidance.
The tax professional must be familiar with the requirements for qualified distribution and tax treatment of Roth IRA distributions that are unqualified.
