While it’s common for clients to automatically slip Roth accounts into the tax-free bucket when it comes to retirement income planning, Roth distributions can result in tax liability if a client isn’t careful.
It’s possible that taxes and penalties might apply for clients who have not yet reached age 59.5 or satisfied a five-year waiting period. The picture can become even more complicated when a surviving spouse inherits a Roth IRA and fails to consider the five-year rule and factor their age into the equation.
When clients are planning their distribution strategies for inherited Roth accounts, it’s critical to consider: Whose five-year rule is relevant to the tax picture? Clients who have recently inherited IRAs should be carefully advised to avoid inadvertently converting a tax-free Roth IRA into one that generates unexpected tax liability.
Taxation of Roth Distributions: The Basics
Because Roth accounts are funded with after-tax dollars, distributions are generally tax-free. However, it’s possible that earnings on the contributions will become subject to tax if the client does not satisfy a five-year holding period rule and has yet to reach age 59.5. In addition, if the five-year holding period is not satisfied and the client is younger than 59.5, taxes and a 10% penalty will apply to the earnings.
If the client is at least 59.5 and five years have passed, all Roth IRA distributions become tax-free, including the earnings.
The IRA holding period requirement is satisfied when five years have passed since the owner made a contribution to any Roth IRA. However, the five-year clock starts to run on Jan. 1 of the year that the account owner made the first contribution, not on the date of the actual contribution. For example, if the contribution was made on April 1, the clock starts to run on Jan. 1. The first Roth IRA contribution gets the five-year clock running for all Roth IRAs, even those that are opened in the future.
And while a typical Roth IRA is not subject to lifetime minimum distribution rules, inherited Roth IRAs are subject to the same RMD rules as traditional IRAs.
Five-Year Clock for Inherited Roth IRAs
When a surviving spouse inherits a Roth IRA, they have two key options. They can maintain the Roth IRA as an inherited Roth IRA or execute a spousal rollover to treat the Roth IRA as their own.
The surviving spouse opting to maintain the account as an inherited Roth IRA can be a valuable choice to allow full penalty-free access to the account if the surviving spouse has yet to reach age 59.5. The surviving spouse still wouldn’t have to worry about taking RMDs until the deceased spouse would have turned 73 and their RMD obligations would have kicked in.
Before the earnings can be withdrawn tax-free, the survivor will have to wait until the deceased spouse’s five-year holding period runs out if the deceased spouse had yet to satisfy their own five-year holding period before death. Remember, though, that there is a set order in which Roth funds are treated as distributed. Distributions from a Roth IRA are treated as including earnings only in cases where all direct contributions and converted funds have already been withdrawn. Because taxes have already been paid on the contributions and converted amounts, those funds would not be subject to tax a second time.
If the surviving spouse needs access to the full value of the account and the five-year holding period has not been met, they can’t simply substitute distributions from another Roth IRA that had met the holding period unless the substitute Roth IRA was inherited from the same decedent.
When a surviving spouse is at least 59.5, the spousal rollover option is likely advantageous. In that scenario, it’s as if the Roth IRA had belonged to the surviving spouse from the outset. The surviving spouse can also elect to use their deceased spouse’s five-year period or their own, whichever is more advantageous.
No RMDs would be necessary because Roth IRAs are not subject to the lifetime RMD rules. RMDs are required only when the Roth is an inherited account.
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