© 2016 Joan E. Emery
Let’s look at some possible beneficiaries and some possible distributions for a Roth Individual Retirement Account (“IRA”). Please note that this discussion assumes that the deceased IRA owner designated the beneficiary in a written beneficiary designation. This discussion focuses on some of the possible federal income tax ramifications and does not discuss the federal estate tax implications.
1. Roth IRA Distribution Options – In order to be a qualified distribution (and thus not subject to federal income taxation), a distribution from a Roth IRA must satisfy the 5 year holding period rule and a “qualifying event” must occur. A key “qualifying event” is the death of the Roth IRA owner. The 5 year holding period rule requires that the distribution not be made before the end of the 5 year holding period which begins with the tax year in which the IRA owner first made a contribution to a Roth IRA. The 5 year holding period ends on the last day of the fifth tax year after the holding period commenced. If the Roth IRA owner dies, his or her holding period carries over to the beneficiary. Upon the IRA owner’s death, after the 5 year holding period is satisfied, a distribution to a beneficiary of the owner’s Roth IRA will be a qualified distribution. The balance of this discussion assumes that the 5 year holding period requirement has been satisfied.
a. Individual Beneficiary
1) Distribution of the Entire IRA Account Balance to the Individual – From an income tax standpoint, taking a distribution of the entire balance in the IRA would negate some of the tax benefits of having a Roth IRA. Since the investment returns accumulate and are distributed free of federal income tax (assuming the distributions are qualified distributions), then taking distributions sooner rather than later reduces the benefit of tax-free investment growth of the funds in the Roth IRA.
2) Spouse is Beneficiary – If the spouse has an unlimited right to withdraw amounts from the deceased owner’s Roth IRA and the spouse is the beneficiary, the spouse has the unique options to (1) rollover the deceased owner’s Roth IRA to his or her own existing Roth IRA or (2) make a special election to treat the deceased owner’s Roth IRA as his or her own Roth IRA. Generally, the spouse elects to treat the deceased owner’s IRA as his or her own IRA by re-designating the IRA account as belonging to the spouse as owner of the account. Additionally, the spouse may be treated as having made the election if certain other requirements are satisfied. The benefit to the surviving spouse of using these options is that there is no required beginning date for Roth IRA distributions during the spouse’s lifetime. These two unique spousal options are often, but not always, the best income tax alternatives for a surviving spouse. To the extent that the surviving spouse is not considered to have adopted one of the above options, he or she will be treated as the beneficiary of an inherited Roth IRA and will have to take minimum required distributions.
3) Individual other than Spouse is Beneficiary - The beneficiary cannot treat the deceased owner’s IRA account as though the beneficiary was the owner of the account. However, the beneficiary can elect to treat the deceased owner’s IRA as an inherited IRA (this is sometimes referred to as a “stretch IRA”).
a) The beneficiary generally must take required minimum distributions starting in the year after the IRA owner’s death. The required minimum distributions are based on the beneficiary’s life expectancy.
b) 5 Year Payout – In a few limited circumstances, the beneficiary could be required to receive the entire account balance by the end of the fifth year following the year of the Roth IRA owner’s death. This is referred to as the “5 year payout rule.” Generally, a 5 year payout rule distribution is not much better, from an income tax standpoint, than the lump sum distribution because the entire IRA must be received by the end of the fifth year following the year of the IRA owner’s death.
b. Trust is Beneficiary –
1) Distribution of the Entire IRA Account Balance to the Trust - See discussion at paragraph 1.a.1), above.
2) A complete explanation of the rules involving a trust as a beneficiary is beyond the scope of this discussion. It is important to note that the trust as beneficiary rules are complicated. If certain requirements are met, minimum required distributions to a trust will be calculated under the favorable “see through trust” rules, which are also sometimes referred to as the “designated beneficiary” rules. With a Roth IRA, the benefit of satisfying the “see through trust” rules is the ability to stretch out the payout of the Roth IRA.
a) If the trust qualifies as a “see through trust,” required minimum distributions must begin by December 31st of the year following the IRA owner’s death.
b) The general rule is that, to the extent that the trust cannot or does not qualify as a “see through trust,” distribution must be made by December 31st of the fifth year after the IRA owner’s death.
c. Estate is Beneficiary –
1) Distribution of the entire IRA Account Balance to the Estate – See discussion at paragraph 1.a.1), above.
2) The general rule is distribution must be made by December 31st of the fifth year after the IRA owner's death. d. Qualified Charity is Beneficiary – From an income tax standpoint, naming a qualified charity as beneficiary would not be a good choice because there would be no income tax benefit to naming a tax-exempt qualified charity as beneficiary of a Roth IRA.
e. Distribution as a Result of a Disclaimer – is beyond the scope of this discussion.
2. Caveat: It is important to consult with your tax advisor before taking any action, so that your tax advisor can determine how these general rules impact your specific situation, especially because these general rules involve numerous particular requirements, special circumstances, and unique exceptions.
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