Roth IRAs are a great planning tool. Not only for your own retirement, but if you want to pass along a gift to a beneficiary, such as a child. I’ve been having more and more conversations about Roth conversions and transferring Roth IRAs to children after a client passes. I know I’m not alone in these conversations as other advisors are having the same discussions. However, there is something important to mention with inherited Roth IRAs that most advisors seem to leave out of the conversation – kids who inherit Roth IRAs have to deal with RMDs (Required Minimum Distributions). This is a rather significant issue and one I wanted to spend a few paragraphs outlining.
I would be remiss if I didn’t mention the basics of Roth IRAs. Contributions go into Roths after taxes, so there is no immediate tax benefit. However, growth and distributions come out tax-free, as long as you meet the rules. The two primary ones are the Roth has been open at least five (5) years and the account holder is 59 ½ years old. Also, and this is a big benefit to Roths – there are NO RMDs for the account holder. Let’s get onto the inherited RMD issue.
When it comes to Non-Spousal Inherited Roth IRAs, the rules do change. All of a sudden, the benefit of no RMDs no longer applies. However, the tax-free growth and distribution rules still apply as long as the account was opened at least five (5) years ago. There are three basic choices when it comes to taking distributions out of the inherited Roth.
- Lump-Sum – This is rather straight-forward as the non-spousal beneficiary takes everything in the inherited Roth out in one lump-sum.
- 5-Year Method – With both this option and the next one, you need to open an Inherited Roth account to put the Roth you just inherited into it. Now, once you have done this you have until the end of the 5th year after the year of death of the original Roth owner to empty the new Inherited Roth. Most people take out equal distributions every year for five years.
- Life Expectancy Model – Again, first step is to open an Inherited Roth account. Once you’ve done this RMDs must begin by Dec. 31st of the year following the year the person passed away. Distributions (RMDs) are based on your life expectancy table at the good old IRS, assuming you are the sole beneficiary. If there is more than one beneficiary (maybe you have siblings), the life expectancy is based on the oldest beneficiary’s age. There is an easy workaround for this, in case there is a big age difference between the oldest and youngest beneficiaries. That is to establish separate Inherited Roth accounts by the time the RMDs are supposed to start. Finally, for both this and the 5-Year Method, you can elect your own beneficiaries.
When it comes to Inherited Spousal Roths, I only have one piece of advice – Make sure your spouse is the ONLY primary beneficiary!!! If this is the case, they can then just roll the inherited Roth into their own Roth and not have to deal with RMDs. But, if you do something like put your spouse down as 50% primary beneficiary and your two kids at 25% primary beneficiaries, then RMDs will apply like mentioned above. Do NOT do that, at least in my opinion. If you want your kids to inherit some Roth money as soon as you die, open separate Roths for them and then designate them as beneficiaries, but leave the one for your spouse as a Sole one.
One last point to stress. Do NOT wait too long to open a Roth if you are planning to leave any to your spouse or kids. You must comply with the rule that the Roth was open for at least five (5) years before you passed otherwise earnings will become taxable. So, if you have never had a Roth and decide to open one on your death bed, well, maybe not the best planning strategy.
Again, Inherited Roths are becoming a bigger and bigger topic in estate planning and this trend will continue. Just know that in most cases the RMD factor with a Roth changes when a non-spouse inherits it. I’d love to say most advisors know this, however, it is a rather unique rule and my experience has been not all of us do know it. Now you can test your advisor to see if you are smarter than them. If so, well, who knows what else they may have missed.