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Inheriting a Roth IRA: What You Need to Know

11.01.23 // Planning & Retirement // Blog Article //

Written by Carson Hamill CIM®, CRPC®, Associate Portfolio Manager and Assistant Branch Manager & Dean Moro BComm, CIM®, Associate Portfolio Manager

An Inherited Roth IRA is a Roth IRA account established as a result of the original holder of the Roth IRA passing away. Roth IRAs are specialized retirement savings accounts offering significant tax advantages. The specific regulations and tax implications applicable to your inherited Roth IRA hinge on your relationship with the deceased account holder, and the timing of the inheritance. In this blog we discuss the implications of inheriting a Roth IRA.

What Is an Inherited Roth IRA?

An inherited Roth IRA, also known as a Roth IRA inheritance, refers to an individual retirement account (IRA) that has been passed down to a beneficiary upon the death of the original account holder.

The Implications of Inheriting a Roth IRA

When you inherit a Roth IRA, it can enjoy the same U.S. tax benefits as the original account. This means you can withdraw the contributions, which were already taxed, at any time without incurring tax or penalties.

The "Five-Year Rule” stipulates that if the Roth IRA has existed for at least five years, you can withdraw earnings tax-free. However, if the account is younger than five years, earnings may be subject to income tax and penalties. The five-year clock starts with the original Roth IRA owner.

The SECURE Act, effective from 2020 onwards, changed how inherited IRA distributions work. If your loved one passed away in 2020 or later, you are not required to take minimum distributions (RMDs), but you must withdraw the entire IRA balance within a 10-year period. This eliminates the option of stretching distributions over your lifetime.

However, there are exceptions under this new law. Beneficiaries known as "eligible designated beneficiaries" can still stretch out distributions based on their life expectancies. You qualify as an eligible designated beneficiary if:

  • You inherit the Roth IRA from your spouse, allowing you to treat it as your own and avoid RMDs. Alternatively, if you open a new inherited Roth IRA, you can take RMDs but stretch them over your lifetime.
  • You are the minor child of the original account owner, permitting distributions based on your life expectancy until you reach 18 or the age of majority in your state. After that, you have a 10-year window to withdraw the remaining funds. If you are in school, you can often delay the 10-year period until age 26.
  • You are chronically ill or disabled.
  • The original Roth IRA owner was less than 10 years older than you.

For situations where your loved one passed away in 2019 or earlier, the old rules apply. In such cases, if you inherit a Roth IRA from someone other than your spouse, you must take RMDs. These RMDs can be stretched over your lifetime using IRS life expectancy tables, which estimate your remaining lifespan based on your age.

Inheriting Your Spouse's Roth IRA: Options and Considerations

When inheriting a Roth IRA from your spouse, your options are different than for other types of beneficiaries.

Your options are as follows:

  1. Ownership Transfer: You can designate yourself as the account owner or move the assets into your existing Roth IRA if you are the sole beneficiary. In this scenario, the assets are treated as if they were always yours. However, if you withdraw earnings before reaching age 59 ½, there may be tax and early withdrawal penalty implications.
  1. Inherited IRA: Another choice is to open an inherited IRA, also known as a beneficiary IRA. You cannot contribute more funds to this account. But as spouses are considered eligible designated beneficiaries, you can stretch distributions over your lifetime. There's no penalty for withdrawing earnings before age 59 ½. This option is particularly useful for IRAs with multiple beneficiaries.
  2. Lump-Sum Distribution: If the Roth IRA has been open for at least five years, you have the option to receive the funds in a lump sum without incurring taxes. However, if the account is younger than five years, there could be tax implications when taking distributions. Opting for a lump-sum payout means forgoing the opportunity to continue growing the account tax-free.

Inheriting a Parent's Roth IRA

When you inherit a Roth IRA from a parent, it's treated similarly to inheriting one from any non-spouse. Your choices are somewhat restricted because you cannot treat the account as if it were yours initially.

If you inherit a Roth IRA from a parent or non-spouse who passed away in 2020 or later, your options include the following:

  1. Inherited IRA with a 10-Year Distribution Rule: You can open an inherited IRA but must withdraw all the funds within a 10-year period. While you're not subject to Required Minimum Distributions (RMDs), the maximum distribution timeframe remains 10 years.
  1. Inherited IRA with Lifetime RMDs: If you qualify as an eligible designated beneficiary, you can open an inherited IRA and spread RMDs over your lifetime.

For those inheriting a Roth IRA from a parent or non-spouse who died in 2019 or earlier, the following options apply:

  1. Inherited IRA with Lifetime RMDs: You can open an inherited IRA, take RMDs, and extend these distributions over your lifetime. This approach can optimize the account's tax-free growth.
  2. Inherited IRA with a Five-Year Withdrawal Schedule: Alternatively, you can open an inherited IRA and withdraw all the funds within five years. In this case, RMDs are not mandatory if you deplete the account within this timeframe.

In either case, you have the flexibility to consider a lump-sum distribution, which is tax-free and penalty-free, regardless of your age, as long as the Roth IRA has been established for at least five years.

What to Do If You Are the Beneficiary of a Roth IRA

When you inherit a Roth IRA, a key strategy is to keep the assets in the account for as long as possible, to benefit from continued tax-free growth. For U.S. tax purposes, the gains within an IRA remain untaxed, regardless of how much the account grows – a fundamental advantage of Roth IRAs.

However, it's crucial to thoroughly comprehend and adhere to all the rules governing inherited IRAs. Failing to annually withdraw the required amount specified by the IRS can result in costly penalties.

Before making decisions regarding your inherited Roth IRA, it's wise to seek guidance from an experienced tax advisor. This will ensure compliance with the rules and regulations and help maximize the growth potential of the inherited assets.

The Importance of Naming a Beneficiary for Your Roth IRA

For Roth IRA holders, designating a beneficiary is a crucial step. This ensures that any remaining assets in your account will seamlessly pass on to the individuals you've chosen as beneficiaries. Typically, beneficiaries include surviving spouses or children, but they can also be extended to other family members or close friends.

Can I Hold an Inherited Roth IRA If I Reside in Canada?

Yes, as a Canadian resident you can certainly hold an Inherited Roth IRA. You will want to work with a cross-border financial advisor who is licensed in both Canada and the U.S. and has the ability to administer and manage U.S. retirement accounts. Discuss the Canadian ta implications with your tax accountant.

Summary

It's important for beneficiaries of inherited Roth IRAs to understand the rules governing these accounts, as there can be tax consequences for not adhering to the regulations. Consulting with a financial advisor or tax professional is often recommended to make the most informed decisions regarding an inherited Roth IRA.

Next Steps

If you’re planning on moving to Canada and need assistance with your investments, estate planning, and portfolio management, please call or email us at Snowbirds Wealth Management as we specialize in cross-border financial planning and wealth management. We work closely with experienced cross-border lawyers and accountants to ensure you have a team behind you.

About Snowbirds Wealth Management

Gerry Scott is a portfolio manager and founder of Snowbirds Wealth Management, an advisory firm focussed on the cross-border market. Together with Dean Moro and Carson Hamill, associate financial advisors and assistant branch manager with Snowbirds Wealth Management, they provide investment solutions for Americans living in Canada, and Canadians residing in the United States. Licensed in both Canada and the US, they provide tailored investment solutions to minimize the tax burden when moving assets across borders.

To schedule an introductory call, please click here.

Statistics and factual data and other information are from sources RJLU believes to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities nor is it meant to replace legal, accounting, taxation or other professional advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters. The information is furnished on the basis and understanding that RJLU is to be under no liability whatsoever in respect thereof.

Raymond James (USA) Ltd. advisors may only conduct business with residents of the states and/or jurisdictions in which they are properly registered. Investors outside the United States are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this site. Raymond James (USA) Ltd. is a member of FINRA/SIPC.

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