In this day and age, people have increasing questions about how they can maximize the value of funds that were inherited from the balance of a retirement account. In this piece, authors Robert Bloink and William Byrnes examine the right ways to roll inherited retirement funds into and inherited Roth IRA in order to avoid unexpected surprises.
[x_pullquote cite=”Robert Bloink and William Byrnes” type=”left”]“The complex set of rules that apply to inherited Roth accounts can make rolling inherited funds into these accounts less attractive for some clients, so understanding the rules can make all the difference in avoiding surprises in the future.”[/x_pullquote]
Inheriting the balance of a retirement account has become a much more common occurrence in recent years — meaning that clients increasingly have questions as to what, exactly, they can do with these funds in order to maximize their tax savings potential in future years.
One of these potential questions involves the possibility of rolling inherited retirement funds into an inherited Roth IRA in order to maximize tax-free income options in the future. The rules governing these types of rollovers are complicated — providing an accurate answer depends upon both the type of plan and beneficiary involved — and the inherited Roth account may be subject to distribution requirements that can potentially make this option less attractive to some clients.
Rolling funds into an inherited Roth
Whether inherited retirement account funds can be rolled over into an inherited Roth IRA depends, first, upon whether the designated beneficiary is the original account owner’s spouse. If the beneficiary is a spousal beneficiary, he or she has the option of rolling the account balance into a Roth IRA regardless of whether the original account was a traditional IRA or an employer-sponsored plan (such as a 401(k)).
A non-spousal beneficiary of a traditional IRA, however, cannot transfer those funds into a Roth IRA because he or she is not permitted to do a rollover of the inherited IRA — and a Roth conversion is treated as if it were a rollover.
A non-spousal beneficiary of an employer-sponsored plan may be permitted to convert the inherited funds to an inherited Roth IRA if he or she is the designated beneficiary (meaning the beneficiary listed on the account beneficiary form, rather than one who inherits through the estate). The rollover must be accomplished through a direct trustee-to-trustee transfer into the inherited Roth IRA.
Pros and cons of converting to an inherited Roth
For most clients, determining whether to convert inherited retirement funds to a Roth IRA first involves consideration of the tax consequences — the amount converted will be included in the beneficiary’s income in the year of conversion. Therefore, if the beneficiary is in a low income tax bracket in the year of conversion, the strategy may prove attractive (especially if he or she expects to move into a higher tax bracket in the future).
However, the non-spousal beneficiary will have to take required minimum distributions (RMDs) with respect to the inherited Roth IRA—unlike in the case of a Roth IRA generally, where the original owner would not have RMDs. The amount of the RMD depends upon whether or not the decedent had begun taking distributions from his or her employer-sponsored account.
If the original account owner had already begun taking the RMDs from his or her employer-sponsored account, distributions must be made at least as rapidly as they would have been under the distribution method in effect when he or she died. If the original owner had not yet begun to take RMDs, the entire balance must be distributed either within five years, or over the designated beneficiary’s life expectancy.
Therefore, while the inherited Roth IRA funds will grow untaxed and withdrawals are tax-free, the owner of an inherited Roth IRA does not have the option of allowing all of the funds to remain in the account indefinitely.
Click here to read a blog with even more details about inherited IRAs.
The complex set of rules that apply to inherited Roth accounts can make rolling inherited funds into these accounts less attractive for some clients, so understanding the rules can make all the difference in avoiding surprises in the future.