An inherited Roth IRA is far from simple to handle. If you think that it is possible to inherit a Roth IRA without paying any taxes – you thought correctly unless you inherit more than the taxable inheritance minimum, which was $5,000,000 in 2011. You can avoid paying income taxes (emphasis on can) if you do everything correctly and obey the rules that pertain to Roth IRAs.
The Rules for an Inherited Roth IRA
To avoid income tax when inheriting a Roth IRA you have to observe some rules. For one, don’t just withdraw the money from the Roth IRA without checking your situation and the facts first. Doing otherwise will easily result in you losing a large chunk of the inheritance to taxes.
If you are the spouse of the late person, you have the ability to merge the assets of the Roth IRA into a Roth IRA of your own and continue with your IRA as if all the money had been yours from the beginning. That also implies that you pay a 10% early withdrawal penalty if you decide to withdraw money before your Roth IRA reaches the five year mark. Inherited Roth IRAs generally void the 10% penalty rule, but you don’t have an inherited IRA anymore after you merged it into your own IRA.
If you are a person other than the spouse, this option is not available to you. You are neither allowed to contribute to the inherited IRA nor are you allowed to merge the account with your own Roth IRA. That leaves you with two other options.
Options for an Inherited Roth IRA as a non-spouse
1) The full distribution payout must occur within five years of the owner’s death the timer starting on the next January, 1. If you do wait until the very last moment to do this, the income is tax free since the inherited Roth IRA has reached the five year mark by then. Remember, Roth IRAs become income tax exempt after 5 years of existence.
2) The other option is to take distributions over your life expectancy. This has to start no later than Dec. 31 of the year after the late owner’s death. In this case, distribution may start before the 5 year mark. But the distribution is first made from contributions and not from earnings, and payout from contributions is generally income tax exempt. Only if the payout comes from actual Roth IRA earnings before the 5 year mark will the distribution be subject to income tax.
There is no option to keep the inherited Roth IRA operating normally for non-spouse beneficiaries.
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