Experts say that a common income tax-saving technique has gained traction as retirees think about their legacy.
The method, called a Roth individual retirement account conversion, involves transferring funds from a pretax or nondeductible IRA to a Roth IRA, starting the future growth of the account tax-free. The trade-off is upfront taxes on the converted balance.
Director of Mariner Wealth Advisors in Greenville, South Carolina and certified financial planner Ashton Lawrence stated that for some clients, “royal conversions are now becoming more of a piece of legacy planning.”
Heirs could spread out their lifetime IRA withdrawals prior to the Secure Act of 2019, which helped lower annual income and tax obligations. But now, there’s a shorter period for some heirs—most adult children among them—to close down inherited IRAs.
According to Lawrence, when retirees pass away, their children will “probably be in their peak earning years” and be in a tax bracket that is relatively high.
Because adult children typically have to empty inherited IRAs over ten years after the original account owner’s death, that could present a tax issue, he said. The rule applies to accounts inherited on Jan. 1, 2020, or later.
Understanding the Rules for Inherited IRAs
Inheriting an IRA can be a significant financial windfall, but it’s crucial to understand the tax implications and rules surrounding inherited IRAs before making any decisions. While you may be tempted to roll over the inherited IRA into your own Roth IRA, the answer isn’t as straightforward as you might think.
Distinguishing Between Spouse and Non-Spouse Beneficiaries
The key factor determining your options is whether you inherited the IRA from your spouse or someone else.
Spouse Beneficiaries:
If you are the surviving spouse, you have two options:
- Treat the IRA as your own: You can continue the deceased spouse’s IRA as your own, inheriting the same tax treatment and distribution rules. This option is only available if you are the sole beneficiary and have unlimited withdrawal rights.
- Roll over the IRA into your own IRA: You can roll over the inherited assets into your existing traditional IRA or convert them to a Roth IRA. This allows you to manage the funds within your own retirement portfolio.
Non-Spouse Beneficiaries:
If you inherited the IRA from someone other than your spouse, you cannot roll it over into your own IRA. Instead, you have two options:
- Open an inherited IRA account: This account remains in the deceased’s name, and you are the beneficiary. You cannot make additional contributions, and your distribution options will depend on your eligibility as an eligible designated beneficiary (EDB).
- Withdraw the money: You can take a lump-sum distribution, but be aware that you will owe income tax on the taxable amount and may face an additional 10% federal tax for early withdrawals if you are under 59½.
Navigating the Complexities of Inherited IRAs
The rules surrounding inherited IRAs can be complex, and it’s essential to consult a tax advisor before making any decisions. They can help you understand your specific situation, determine your eligibility as an EDB, and guide you through the distribution options and tax implications.
Key Considerations for Inherited IRA Management:
- Tax Implications: Both distributions and conversions have tax implications. Consult a tax advisor to understand the potential tax consequences of your choices.
- Distribution Rules: The distribution rules for inherited IRAs differ depending on whether you are an EDB and the date of the account owner’s death.
- RMDs: Required minimum distributions (RMDs) apply to inherited IRAs, typically starting at age 73. Consult a tax advisor to understand the RMD rules and potential tax penalties for missed distributions.
- Beneficiary Designations: Review and update your beneficiary designations to ensure your wishes are reflected in your estate plan.
Making Informed Decisions for Your Financial Future
Inheriting an IRA presents both opportunities and challenges. By understanding the rules, consulting a tax advisor, and carefully considering your options, you can make informed decisions that align with your financial goals and minimize potential tax liabilities. Remember, the right approach depends on your individual circumstances, so don’t hesitate to seek professional guidance to navigate the complexities of inherited IRAs.
How Roth conversions can benefit heirs
“Roth conversions look even more attractive today,” according to Robert Dietz, national director of tax research at Minneapolis-based Bernstein Private Wealth Management, because many IRA heirs have a 10-year withdrawal window.
Adult children typically still have ten years to withdraw funds from inherited Roth IRAs. However, if the account has been open for at least five years, withdrawals are normally tax-free.
According to Lawrence, there are situations in which parents who pay taxes on the Roth conversion up front can have a lower tax burden than their children who pay taxes on IRA withdrawals. But before making that choice, families need to have “legacy conversations” and review their tax situation.
Naturally, the original IRA owner must also consider the financial ramifications of increased income for the years of the Roth conversion, including increased Medicare Part B and D premiums.
Can I convert an inherited IRA, 401(k) or 403(B) to a Roth IRA?
FAQ
Can I transfer an inherited IRA to a Roth IRA?
What is the best thing to do with an inherited IRA?
Can you roll inherited money into a Roth IRA?
Can I roll over a inherited IRA to a Roth IRA?
You can only make this election if you are the sole beneficiary of the IRA and have an unlimited right to withdraw amounts from it. Treat it as your own by rolling to an IRA in your name. If you already have an IRA, you can roll over the inherited assets to another traditional IRA in your name or convert the assets to a Roth IRA.
Can a spouse convert an inherited IRA into a Roth IRA?
A spouse can roll over part or all of the inherited IRA to their own IRA. This is the only known instance in which you can convert an inherited IRA into a Roth IRA. But technically, a surviving spouse would rollover the deceased spouse’s IRA into their own IRA. From there, the spouse would do a Roth IRA conversion into their own Roth IRA.
Can a spouse roll over an inherited IRA?
A spouse can roll over part or all of the inherited IRA to their own IRA. A spouse doesn’t have to roll the inherited IRA into their own IRA. A spouse doesn’t have to take RMDs right away. Persons not more than 10 years younger than the owner of the IRA.
Are inherited IRAs taxable?
This is known as an “ inherited IRA You could immediately cash out traditional or Roth IRAs through a lump sum distribution. With traditional IRAs, withdrawals are taxable income. However, withdrawals from Roth IRAs (as long as the account was open for at least five years) are tax-free.