When the estate is the beneficiary of an inherited Roth IRA, the executor must handle the distribution of the account. How the executor handles the distribution process depends on IRS regulations. Essentially, the IRS requires distribution of the account using rules based on the age of the IRA owner at death. Aside from the age based rules, other regulations that apply to the inherited Roth IRA provide the IRA with diverse characteristics. Accordingly, the executor must understand these rules to handle the account competently. Particularly,when the estate is the beneficiary of an inherited Roth IRA.

Basic Rules for the Inherited Roth IRA

When the original owner of a Roth IRA perishes, the executor must be aware of the following rules:  

• As long as the original Roth IRA owner remains alive, there are no required minimum distributions.  

• Only non-spouse beneficiaries must take required minimum distributions after the death of the original Roth IRA owner.

• The IRS sets the minimum distribution rules for a Roth IRA as though the owner died before the required beginning date. 

• Distributions are tax-free on qualified distributions.

These rules present the inherited Roth IRA with different characteristics than other similar retirement accounts. Therefore, the executor should understand these rules to avoid problems.

Distribution Rules for Inherited Roth IRA’s with the Estate as Beneficiary

Basically, the IRS establishes guidelines for distributions after a Roth IRA owner’s death. In the IRS Publication 590-B, the IRS establishes the following rule:

If a Roth IRA owner dies, the minimum distribution rules that apply to traditional IRAs apply to Roth IRAs as though the Roth IRA owner died before his or her required beginning date.

Additionally, the IRS sets the following rule concerning distributions for beneficiaries in the same publication:

Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the year of the owner’s death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary.

Finally, one last rule the IRS establishes concerning distributions when the beneficiary is not an individual:

The 5-year rule applies in all cases where there is no individual designated beneficiary by September 30 of the year following the year of the owner’s death or where any beneficiary isn’t an individual (for example, the owner named his or her estate as the beneficiary).

The outcome of these three guidelines set by the IRS for the inherited Roth IRA is the same for the inherited traditional IRA as described in the article Traditional IRA | Distribution Rules for Estate as Beneficiary. The executor will have the following two options to distribute the inherited Roth IRA:

1. Opt for the 5-year rule, or
2. the lump sum.

The 5-year rule Considerations for the Executor

The 5-year rule is a less attractive option for an executor of a common estate because of the characteristics of the rule. In Publication 590-B the IRS explains the 5-year rule as follows:

The 5-year rule requires the IRA beneficiaries to withdraw 100% of the IRA by December 31 of the year containing the fifth anniversary of the owner’s death. For example, if the owner died in 2017, the beneficiary would have to fully distribute the plan by December 31, 2022. The beneficiary is allowed, but not required, to take distributions prior to that date. The 5-year rule never applies if the owner died on or after his or her required beginning date.

In most cases, the executor of a common estate would prefer choosing the lump sum over the 5-year rule. The following factors would influence the decision:

• Opting for the 5-year rule will require managing the account beyond the closing of the estate, or at least extending probate.

• Qualified distributions from an inherited Roth IRA are tax-free.

In common estates, most executors would like to close the estate on time. Therefore, when the estate is the beneficiary, the executor would most likely opt for taking the lump sum.

Of course, the IRA agreement may take away the decision from the executor. Unfortunately, some financial institutions may force the executor into the lump sum if the estate is the beneficiary. Therefore, similar to the inherited traditional IRA, the 5-year rule may not be an option.

Tax Considerations and Penalties for the Inherited Roth IRA

In general, the IRS establishes that qualified distributions from an inherited Roth IRA are tax-free. However, it’s possible that not all distributions meet the criteria of a qualified distribution. The IRS states that distributions are tax-free as long as the distribution was made after the 5 year period beginning with the first taxable year for which a contribution was made to a Roth IRA. So, if the Roth IRA owner died before the 5 year anniversary of the account opening, taxes may be due on future distributions. Therefore, the executor needs to know when the Roth IRA owner opened the account to plan properly.

Additionally, if individuals neglect the rules for required distributions, the IRS will assess penalties. The IRS will assess a 50% tax on the amount of distributions not taken. This is a heavy tax, so when the estate is the beneficiary, the executor must be aware of the 5-year rule. If the inherited Roth IRA is not fully distributed by December 31^st of the 5^th year, the IRS will apply a 50% tax on the remaining distribution amount.

Conversely, not all is bad news. If a Roth IRA owner dies, beneficiaries will not have to pay a 10% penalty on distributions.

Conclusion

Unfortunately, poor estate planning will throw an executor into this confusing IRA mess. The IRA distribution process becomes much easier when the designated beneficiary is an individual. When an individual is the designated beneficiary, the account transfers to the beneficiary and away from the estate. As a result, the estate administration becomes much smoother for the executor. So, while planning your estate, make sure to properly designate a person as the beneficiary of your IRA. Otherwise, you will create havoc for your executor.

Do you understand why the 5-year rule is the only option for distributing the inherited Roth IRA other than taking a lump sum? Is this article helpful in clearing some confusion over the inherited Roth IRA? Share your comments or questions in the comment box below. 

Recommended Reading

Publication 590-B, Distributions from Individual Retirement Arrangements(IRAs)

Plan Your Estate – Plan Your Estate will guide you on how to treat your retirement accounts in your estate plan.