01 Jun I inherited a Roth IRA. Will I owe taxes on it?

Q. My uncle left me a Roth IRA in his will when he recently died. On my beneficiary claim form, I’m requesting a lump sum. Do I check off to withhold New Jersey state income tax? I did check off the federal income tax to be withheld at 10%.
— Nephew

A. We’re sorry to hear about your uncle.

Before we answer your question about tax withholding, let’s go over how the rules for Roth IRAs are different from traditional IRAs, and what has changed with the SECURE Act.

A traditional IRA is usually funded with pre-tax dollars or after-tax dollars, and then the funds grow on a tax-deferred basis, said Melissa Raimundo, a certified financial planner with Beacon Trust in Morristown.

She said withdrawals after age 59 ½ from traditional IRAs are taxable as ordinary income.

But with a Roth IRA, the account holder contributes after-tax dollars and the funds would grow tax-free from that point forward, she said.

“Generally, all withdrawals from the Roth IRA are tax- and penalty-free so long as they begin five years after the account is established and after age 59 ½,” Raimundo said. “While these rules apply to the original account owner, when inherited, similar rules apply for distributions to beneficiaries.”

One important point is to confirm that you are the true beneficiary of an IRA or Roth IRA, by reviewing the beneficiary designation on the account in question.

While there are times that beneficiaries are designated via a will, if there are different beneficiaries designated on the account itself, those beneficiary designations would supersede those listed in the will, she said.

Then, once you establish that you are truly the beneficiary, it is important to ensure that the five-year rule applies on the Roth IRA you are inheriting.

“This five-year rule stipulates that you, as Roth IRA beneficiary, can withdraw both contributions and earnings tax-free from the Roth as long as the account had been open for at least five years at the date of death of the account holder,” Raimundo said. “This rule applies regardless of the distribution method you choose.”

Only when Roth IRA assets have been in the Roth IRA for five or more years can Required Minimum Distributions (RMDs) be taken tax-free, she said. If the account had been opened for fewer than five years, then you would be subject to taxes on the earnings in the account, she said.

When determining the distribution rules for the Roth IRA, it is important to note the date of death of the original account owner.

Accounts with original owners who have a date of death of Dec. 31, 2019 or earlier have a different set of distribution rules than those where the original account owner has a date of death after Dec. 31, 2019, she said.

If the original account owner died on Dec. 31, 2019 or earlier and died prior to their age 70½, you have three options for distribution as a non-spouse beneficiary.

Your first option is to take a lump sum distribution, she said.

“With this option, you can take a withdrawal in the full amount of the IRA all at one time,” she said. “There has been no change to this option with the passage of the SECURE Act.”

Your second option is to distribute using a five-year rule.

It’s important to note that this is a different five-year rule from the one about the duration the account needs to be opened in order to achieve tax-free RMD benefits.

Under this five-year option, you could elect to take distributions of the inherited assets over the five years following the owner’s death and you must withdraw all assets by Dec. 31 of the fifth anniversary year of the IRA owner’s death, Raimundo said.

This is the rule that must be used by non-individual or non-person beneficiaries such as estates or charities, she said.

Your third option as a non-spouse beneficiary is the lifetime distribution option, she said.

“If you choose this option, you would open an inherited Roth IRA, and have the distributions distributed via the life expectancy method,” she said. “This was also known as the `stretch’ option because the distributions would be stretched out over your personal life expectancy.”

With this option, you must begin taking RMDs in the year after the year of death of the original account owner, and use your age and the IRS Single Life Expectancy Table for RMD calculations. But importantly, this option no longer exists for IRAs and Roth IRAs, under the SECURE Act, if the original account owner died on Jan. 1, 2020 or later.

If the original account owner died on Jan. 1, 2020 or after, then you no longer have the option to take advantage of the “stretch” option, Raimundo said.

You now would need to withdraw all assets from the inherited Roth IRA within 10 years following the death of the original account holder instead of your own life expectancy, she said.

“You could still elect either of the other two options that were previously available to you,” she said. “You should also note that exceptions to the 10-year distribution rule apply to assets left to an eligible designated beneficiary which include surviving spouses, a minor child of the deceased owner, disabled or chronically ill individual, or any other person who is not more than 10 years younger than the deceased account holder.”

Under the 10-year rule, you can withdraw from your inherited IRA assets at any time, in any amount within the 10-year time frame, and you must withdraw all assets by Dec. 31 of the tenth anniversary year of the IRA owner’s death, she said.

“Because you mention that your uncle has recently passed, it appears that you would be subject to the 10-year rule.,” Raimundo said. “As long as your lump sum distribution is happening within the 10 years after your uncle’s passing, you should not be subject to penalties.”

In terms of withholding requirements for Roth IRAs, the IRS does not generally require you to withhold federal income tax from your Roth IRA distribution, she said.

“For Roth IRA distributions for which no withholding instructions are provided, no federal income tax will be withheld,” she said. “Your election to have 10% withheld is conservative, but unnecessary.”

Similarly, she said, because distributions from Roth IRAs — assuming they have met the five-year rule — are not subject to income tax, no state income tax needs to be withheld.

“In general, New Jersey is a state that has a voluntary state income tax withholding requirement. This means that state income tax will be withheld only if you instruct the custodian to do so,” she said. “New Jersey does not have a minimum withholding requirement, therefore a dollar amount must be indicated if you would like state income tax withheld. Again, if you wish to have taxes withheld you may do so, although it is not necessary.”

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This story was originally published on June 1, 2021.

NJMoneyHelp.com presents certain general financial planning principles and advice, but should never be viewed as a substitute for obtaining advice from a personal professional advisor who understands your unique individual circumstances.