Own Vs. Beneficiary Roth IRA: Choosing The Right Option For A Spouse Beneficiary
The ultimate goal for a Roth IRA is for it to qualify for tax-free distributions. Spouse beneficiaries must take care to choose the option that leads to tax-free distributions.
A dilemma faced by spouse beneficiaries of IRAs is whether they should move the amounts to Beneficiary IRAs or their own IRAs. For inherited Roth IRAs, there are two key factors that determine which of the two is the better choice: (1) avoiding required minimum distributions (RMDs) and (2) tax-free distributions. In an ideal world, a spouse beneficiary would get both benefits. But in some cases, one must be chosen.
The Benefits That Make A Roth IRA More Attractive Than a Traditional IRA
There are two key benefits exclusive to a Roth IRA that make it more attractive than a traditional IRA.
1. There are no RMDs for owners, and
2. Qualified distributions of earnings are tax-free.
Not being subject to RMDs means that the balance continues to grow tax-deferred for as long as the owner wants. Also, the accumulated earnings become tax-free when taken as qualified distributions.
A distribution is qualified when the following two requirements are met:
1. The owner held a Roth IRA for at least five years, and
2. The distribution is taken when the owner:
——a. Is at least age 59-½
——b. Is disabled, or
——c. Withdraws up to $10,000 for first-time homebuyer purposes.
When determining if a Roth IRA owner meets the first requirement – the 5-year holding period – all of their Roth IRAs are aggregated. Therefore, a Roth IRA funded in 2020 would still meet the 5-year requirement in 2020 if the owner funded another Roth IRA five or more years before 2020.
A distribution would also be qualified if the owner held it for at least five years and dies, and it is transferred to a Beneficiary Roth IRA.
The Options For A Spouse Beneficiary
A spouse who inherits a Roth IRA has two options.
A. Make the inherited Roth IRA their own by moving it to their own Roth IRA or by not taking any beneficiary RMDs, or
B. Transferring it to a Beneficiary Roth IRA.
A spouse beneficiary who makes an inherited Roth IRA their own gets the same benefits as the original owner- no RMDs and tax-free distributions when eligible.
Counting the 5-Year Period for a Spouse Beneficiary
If a spouse beneficiary treats an inherited Roth IRA as their own, the five-year period for the spouse and the decedent are merged, and the earlier of the two stands.
For example: If Jack started a Roth IRA in 2014 and his wife Mary started hers in 2020, Mary’s five-year period would start in 2014 if she inherits Jack’s Roth IRA and makes it her own.
If the spouse transfers the inherited IRA to a beneficiary Roth IRA, the five-year period starts when the deceased first funded their Roth IRA.
For example: If Tim started a Roth IRA in 2018 and his beneficiary Susie inherits the IRA and transfers it to a Beneficiary Roth IRA, the five-year period started in 2018.
Beneficiary Roth IRAs and RMDs
As noted earlier, Roth IRA owners are not subject to RMDs. This is extended to a spouse beneficiary who makes an inherited Roth IRA their own.
But, if the spouse keeps the amount in a Beneficiary Roth IRA, they would be subject to RMD requirements under one of the following options:
A. The 10-year rule: Under this option, distributions are optional until December 31 of the 10th year that follows the year in which the owner died.
B. The life expectancy rule: Under this option, the beneficiary must start taking RMDs over their single life expectancy, beginning by the later of:
a. December 31 of the year that follows the year the owner died, or
b. December 31 of the year in which the owner would have reached age 72.
Failing to take RMDs by the applicable deadlines would result in the beneficiary owing the IRS a 50% excess accumulation penalty on any RMD shortfall.
Which Option is Better? It Depends
Making an inherited Roth IRA one’s own seems like the better choice because it means no RMDs, which allows flexibility with deciding when to take distributions. But the qualified distribution factor must be considered as well. If the spouse beneficiary would be eligible for qualified distributions for their own Roth IRAs- including their deceased spouse’s if it is moved to their own- then moving it to their own Roth IRA is the obvious choice.
However, if the 5-year rule is met but distributions from their own Roth IRA would be subject to the income tax because they are under age 59 ½ and are not disabled or eligible for the first-time homebuyer exception, moving it to a beneficiary Roth IRA would be the better choice.
Example: Dick started a Roth IRA in 2014. The balance is $250,000 which consists of $20,000 in contributions, $80,000 converted from his traditional IRA in 2014, and $150,000 in earnings. His wife, Sue, is under age 59 ½ and she is not disabled.
Dick died in 2020. Sue found out that she has no choice but to withdraw the entire $250,000 in 2021 to cover expenses. Sue’s choice would determine how much would be taxable.
If Sue Makes The Roth IRA Her Own
The 5-year period has been met. But Sue is not eligible for a qualified distribution because she is under age 59 ½ and she is not disabled. Therefore, the $250,000 would be taxed as follows:
- $100,000 ($20,000 + $80,000) would be tax-free because it comes from amounts that were already taxed when added to Dick’s Roth IRA.
- The $80,000 would not be subject to the 10% additional tax because it was converted more than five years ago.
- $150,000 would be taxable at her ordinary income tax rate. An additional tax of 10% would apply because she is under age 59 ½ unless she qualifies for an exception.
If Sue Transfers The Inherited Roth IRA To A Beneficiary Roth IRA
The 5-year period has been met. In addition, the distribution would be taken due to death and would therefore be a qualified distribution. As a result, the entire $250,000 would be tax-free- neither ordinary income tax nor the 10% additional tax would apply.
Not All Spouse Beneficiaries Are Equal
In Sue’s case, choosing a Beneficiary Roth IRA was the better choice. But it could have been different if she had not planned to take a full distribution in 2021. It would also be different for other spouse beneficiaries whose beneficiary profile is not similar to Sue’s.
Before making a choice, a spouse beneficiary should consult with a tax professional who must take the following factors into consideration:
- Whether the 5-year rule has been met,
- Whether the spouse beneficiary is eligible for a qualified distribution from their own IRA vs. a Beneficiary Roth IRA, and if not,
- The option that would result in the least amount of taxes, including avoiding the 10% additional tax.
The tax professional must be knowledgeable about the requirements for a qualified distribution and the tax treatment of Roth IRA distributions that are nonqualified.