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Inheriting A Roth IRA? What If You Are An Eligible Designated Beneficiary?

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Roth IRAs Are Special

Roth IRAs are not subject to income taxation (as long as the account has been open for at least five years). There are no during-your-life forced withdrawals for the owner of the Roth IRA – that is, there are no lifetime required minimum distributions, in contrast to RMDs for traditional, tax-deferred IRAs. The owner can withdraw funds from the Roth anytime after age 59 1/2 without triggering income-tax obligations.

Again, at no time is the Roth IRA owner forced to take withdrawals. And, it’s income-tax free during the lifetime of the owner, even when the owner takes withdrawals. What could be better? Tax-free. Simple. A great savings and investing opportunity.

Then, at some point, the owner passes away, and the owner’s beneficiary inherits the Roth.

Thanks to recent changes in the law (SECURE 1.0 and 2.0), life is a bit more complicated for the beneficiary, simply because the beneficiary needs to choose how to handle inheritor rules.

Let’s go through how that might work using a Forbes.com reader’s situation. (By the way, don’t hesitate to write to me; I read all questions and consider them for response in this column.)

Important Caution

While I will offer general guidelines and reference material here, tax advice regarding your IRAs needs to be customized to your particular situation. Be sure to talk with your tax adviser before taking any action.

Eligible Designated Beneficiary

Let’s take “Joel,” whose sister passed away at age 59. She left him a Roth IRA.

Joel is seven years younger than his sister, which means that he is an “eligible designated beneficiary” or EDB, a new concept brought to us by SECURE 1.0, which took effect in 2020.

An EDB is defined by IRS Publication 590-B as the IRA owner’s “surviving spouse, the owner’s minor child, a disabled individual, a chronically ill individual, or [in Joel’s case] any other individual who is not more than 10 years younger than the IRA owner.”

This differentiates Joel from a “designated beneficiary,” which is an individual who is designated as a beneficiary but who is not an EDB.

The 10-Year Rule

A designated beneficiary inheriting a Roth IRA from someone Joel’s age would have to empty the inherited Roth IRA by the 10th year after the death of the Roth IRA owner. (There would be no interim yearly mandated RMDs.)

EDBs in Joel’s position can opt to use the same rule that applies to designated beneficiaries (the 10-year rule). He has an additional option to consider, the single life expectancy option.

The Single Life Expectancy Option

If Joel chooses the single life expectancy option, which does involve yearly distributions, the inherited Roth IRA would last beyond 10 years – how long would depend on investment performance over time. I’ll review results below, with the benefit of Brentmark software (brentmark.com). (Conflicts disclosure: I subscribe to Brentmark software. Also, the Brentmark website posts links to some of my Forbes articles, for which I receive no compensation from Brentmark.)

The first distribution must come the year after the year of the account owner’s death. Let’s say Joel’s sister died in 2022, so the first inherited Roth IRA RMD would have to be taken by Dec. 31, 2023, and would be based on the Roth IRA value as of Dec. 31, 2022.

If Joel turned 52 in the year that his sister (59) passed away, he would use his age in 2023 (53), the year of his first distribution, and the Single Life Expectancy Table (found in Pub. 590-B in the Appendices section) to determine his life expectancy number (33.4) to calculate his RMD. If his sister’s Roth IRA was worth $100,000 as of Dec. 31, 2022, he would need to withdraw $2,994 for 2023. In subsequent years, he would subtract one from the life expectancy number. (The 2024 RMD would be based on a 32.4 divisor; the 2025 RMD would be based on a 31.4 divisor.)

Assuming a starting value of $100,000 and a 7% annual growth, the inherited Roth IRA would last until 2056, when Joel is 86. The total amount of distributions over time would be more than $365,000.

Back to the 10-Year Rule

If Joel chose the 10-year option, assuming he refrained from taking any withdrawals, the investments would have the chance to grow over the 10-year period. In 2032, he would have to empty the account (by the end of the year).

By the end of that 10-year period, the inherited Roth that started with $100,000 at the end of 2022 would nearly double by the end of 2032, assuming the same 7% annual growth. (In comparison, under the single life expectancy option, Joel’s inherited Roth IRA would be worth around $134,000 in 2032, since he would have been taking yearly distributions.)

The 10-Year Option With Withdrawals

There is nothing preventing Joel from withdrawing more money from the inherited Roth IRA than mandated at any time.

For instance, if Joel chose the 10-year option, nothing prevents him from taking withdrawals during the 10-year period.

Say he took equal distributions with the 7% growth factored in, starting with a $10,000 withdrawal in 2023. Over the next nine-years (again assuming a $100,000 account at the end of 2022), Joel would withdraw a total of nearly $120,000, leaving an ending distribution of approximately $18,385 in the 10th and final year (2032), for a total value of just over $138,000.

Which Option should Joel Choose?

That will depend on the experts Joel will rely on for guidance.

As Nicole Maholtz, the president and CEO of Brentmark, explained: “A savvy adviser would use reliable software to compare all three options and choose the one that works best for the client. Factors include whether the client needs the funds now or can wait until later; and whether the life expectancy option would work better than the 10-year rule, or vice versa. In some cases, it is necessary to include other assets when making the decision.”

From my perspective as someone whose firm works with high-net-worth clients who inherit IRAs, no decision can be made without considering the client’s specific situation. The best option for one person will be the worst for someone else. Everything is situation-specific.

First Things First: Are You an EDB?

What should you do if you inherit a Roth IRA?

Make it a point to determine whether you are an EDB. If you are, you’ll have the option of extending RMDs beyond the 10-year rule that applies to designated beneficiaries.

Get Advice and Don’t Forget to Do Your Homework

Get the advice of your tax professional. Bring your money manager into the picture if he or she has expertise in the field.

And, a final piece of advice from me personally: Like most tax-advantaged investment vehicles, the Roth IRA needs to be understood, and available options mastered. It takes not only expertise, but also an understanding of your particular financial situation and your goals. That calls for careful evaluation and preparation. Homework is involved. Not the kind you will want to avoid or ignore.

Questions

To keep up with topics that I cover, be sure to follow me on the forbes.com site (and if you would like to subscribe, check out the red box at the top right). Write to me at forbes@juliejason.com. Include your city and state, and mention that you are a forbes.com reader. While all questions cannot be answered, each email is read and reviewed and can lead to discussion in a future post.

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