What can children do with an inherited Roth IRA?

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Q. What responsibilities do children have when inheriting a Roth IRA?
— Dad

A. The rules governing distributions from both traditional IRAs and Roth IRAs are complex, both when the owner is alive and when someone inherits the accounts.

Let’s begin with a quick overview.

With traditional IRAs, you generally make tax-deductible contributions, though it’s also possible to make non-deductible contributions to a traditional IRA, said Gene McGovern of McGovern Financial Advisors in Westfield.

He said earnings in the IRA grow on a tax-deferred basis, but when you later withdraw the money, you must pay tax at ordinary income rates on every dollar withdrawn – other than any nondeductible contributions made.

With Roth IRAs, you make contributions with after-tax dollars instead of receiving a tax deduction, McGovern said.

“The money also grows tax-deferred, and withdrawals from the Roth IRA, provided they are `qualified,’ are completely tax-free,” he said. “Note that you can withdraw your contributions to a Roth IRA – but not the earnings – tax-free at any time, since they were made with after-tax dollars to begin with.”

After you reach age 70 1/2, you must begin taking withdrawals from traditional IRAs. These are known as Required Minimum Distributions, or RMDs.

Roth IRA owners, by contrast, are not required to take RMDs during their lifetimes, McGovern said.

However, beneficiaries who inherit Roth IRAs upon the owner’s death must take RMDs.

The rules that govern RMDs from inherited Roth IRAs depend in part on whether the beneficiary was the IRA owner’s spouse – and also the sole beneficiary – or not, McGovern said. Because your question deals with children inheriting a Roth IRA, we’ll discuss the non-spouse beneficiary rules that apply to individuals here.

A non-spouse Roth IRA beneficiary such as a child has three options.

“He or she can, first, take the money now in a single, lump sum distribution,” McGovern said. “Second, he or she can withdraw all the money in the Roth IRA account by the end of the fifth calendar year after the year of the owner’s death, or third, begin taking Required Minimum Distributions based on the beneficiary’s age and life expectancy.”

The RMDs must begin by Dec. 31 of the year following the original Roth IRA owner’s death.

Provided the distributions from the inherited Roth IRA under any of the three options are qualified, they’re tax-free to the beneficiary, McGovern said.

A Roth withdrawal, or distribution, is qualified if it meets two broad requirements.

“First, the distribution must occur more than five years after the first tax year for which the taxpayer made a contribution to any Roth IRA account,” McGovern said, noting we’ll save Roth conversions for another discussion.

Second, he said, the distribution must be made for one of four reasons: the Roth IRA owner was at least 59 1/2 at the time of the distribution; the distribution was used to buy or rebuild a first home (up to $10,000); the distribution was made because the owner was disabled; or the distribution was made to the owner’s beneficiary or estate.

“Thus, assuming the child’s parent made his or her first Roth IRA contribution more than five years before the date of death, the distributions from the inherited Roth account will be tax-free,” McGovern said.

It’s also important t0 note that any RMDs not taken are subject to a 50 percent penalty on the amount that should have been withdrawn.

“Regarding traditional IRA accounts, the child’s RMD options depend on whether the owner died before or after the required beginning date for his or her RMDs,” he said.

It’s best to work with a tax professional or financial advisor who understands the rules so you can be sure no one makes a costly mistake.

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