Non-Spouse beneficiary of Roth IRA converted w/i 5 years
Two adult children inherit Roth IRA from parent, who converted traditional IRA (with no basis) to a Roth earlier in the year. Beneficiaries planned to stretch the Roth distributions as long as possible. Since inheritance occurred within 5 years of Roth conversion, are the earnings taxable every year or just the first 5 years? If earnings will be taxable forever, can the executor undo the conversion (and would that be advantageous)?
Permalink Submitted by Alan Spross on Tue, 2010-11-02 03:28
The executor or other person responsible for filing the final return can opt to recharacterize a Roth conversion, but I think for legal purposes they had better consult with the beneficiaries.
In making the decision to recharacterize, the beneficiary’s present and future tax bracket should be a consideration. If they want to retain the conversion, the taxation of rules are as follows:
1) Account is fully qualified and tax free in the 6th year measured from the year of decedent’s first Roth contribution of any type (not just this conversion).
2) Distributions prior to that year are tax free up to the amount of regular and conversion contributions, and those amounts come out before any earnings come out. So if the plan is to stretch the Roth, the 5 years will be attained before any earnings are distributed. All early withdrawal penalties are waived due to the death exception and that includes the 5 year holding requirement for Roth conversions.
In summary, if they stretch the Roth, distributions prior to qualification will be tax free and of course also will be tax free upon qualification.
The two beneficiaries should create separate accounts by the end of the year following the year of death, so that each can use their own life expectancy for RMD calculation. They should also name their own successor beneficiaries ASAP.
Permalink Submitted by mk foss on Tue, 2010-11-02 03:32
I don’t see that you have a problem with taxation of earnings in your scenario. The earnings are taxable for the first 5 years ONLY if distributed. A nonspouse beneficiary takes distributions based on their life expectancy. The first funds out of the Roth IRA are those that have already been taxed – the conversion amount in your example. The earnings for this purpose are not earnings in the traditional sense but instead the growth in the account.
Here is an example. The conversion was $400K and the nonspouse beneficiary was 70 in the year after the death. The first year the beneficiary withdraws 1/17th of the balance measured by the FMV on 12/31 of the year of death. That’s unlikely to contain any earnings because no earnings are considered distributed until the entire $400k has been withdrawn. If in the second year, they take out $200k instead of just 1/16th, it’s still unlikely that they will burn through the rest of the $400k within the first 5 years.
Permalink Submitted by Jim Armstrong on Tue, 2010-11-02 17:28
Thank you Alan and Mary Kay for your prompt responses. The example in the IRS pub 590 was a full distribution and used proportional allocation. I was unsure of how the five year rule worked and whether you had to use ordering or proportion if it was spread out. Thanks for clarifying.
Permalink Submitted by William Rosenfeld on Tue, 2010-11-02 18:23
Mary Kay –
You may have answered my question. I’m wondering about the 5 year restrictions on a Roth after converting from a Traditional. In particular, the section of the 590 IRS Publication pasted in below. Because it says AND it seems to imply that required distributions by a beneficiary during the 5 years would not be qualified (i.e. would be taxed). Is it just saying that income earned during the 5 years would not be qualified but distributions of the converted principal would be tax free to either the contributor or the beneficiary?
Thanks in advance.
Bill
What Are Qualified Distributions?
A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.
1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, AND
2. The payment or distribution is:
a. Made on or after the date you reach age 591/2,
b. Made because you are disabled,
c. Made to a beneficiary or to your estate after your death, or
d. One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).
Permalink Submitted by Alan Spross on Tue, 2010-11-02 19:25
Yes.
Another way of putting it is that the ordinary income tax is the same for the beneficiary as it would have been for an owner over 59.5, ie never an early withdrawal penalty, but for the earnings to be tax free the 5 year holding period must be met counting both years before owners death and after.