Do My Parents Need to Hold Their Converted Roth IRA Funds For Five Years?

By Sarah Brenner and Jeffrey Levine
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This week’s Slott Report Mailbag answers a question on how to distribute converted funds from a Roth IRA, discusses special required minimum distribution (RMD) rules for IRA beneficiaries and looks at the fine print of IRS Form 8606. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link. 

1.

My parents are both in their 90s, and I suggested that they start converting their Traditional IRAs to Roth IRAs since they could do this over the next few years without paying any taxes in their current tax situation.

Their broker says that any monies transferred to a Roth IRA would have to be in the Roth IRA for five years before they could draw out the monies tax free.

He also said that if they passed away, the beneficiaries would have to leave the monies in the Roth IRA for the five years for the monies to be tax free, otherwise the beneficiary would have to pay taxes if withdrawn.

Is that the case?

Any feedback would appreciated.

Thanks!

Answer:
Nice job thinking outside the box! While you often hear about the benefits of converting to a Roth IRA for younger people, it can be a smart strategy for older people as well. Being in a low tax bracket, as your parents are, can minimize the tax bite of converting. Now as far as what your parents’ broker said… let’s just hope he’s better at investments than he is at taxes! When it comes to tax-free distributions for both your parents and their beneficiaries, there is good news. Your parents, or their beneficiaries, may take distributions of any converted funds in their Roth IRAs at any time both without tax or penalty. More good news is that the converted funds are considered to be the first funds distributed from a Roth IRA. This means that there will be no tax consequences until all the converted funds are distributed. Earnings in the Roth would come out next and those would be taxable to either your parents or their beneficiaries unless it has been more than five years since the year that each parent converted. So, to sum it up, as long as your parents and/or their beneficiaries don’t take out more than they convert in the 5 years that follow their initial conversions, there will never be any additional tax (or penalty). Not a bad deal!

2.

Am I correct that there is a special required minimum distribution (RMD) rule for situations in which the IRA owner dies in the year during which he turned age 70 ½.

If his widow rolls over the IRA into her IRA, and she is younger than 70, does the RMD have to be taken for the year in which her husband died?

Thanks,

Len Coris

Answer:
The rules for RMDs can be tricky. In your situation, the widow would not be required to take an RMD for the year of her husband’s death. Why not? Well, her husband died in the year in which he reached age 70 ½. Therefore, he died before April 1 of the year following the year he turned 70 ½. April 1 of the year following the year an IRA owner reaches age 70 ½ is an important date called the Required Beginning Date (RBD). That is the date by which an IRA owner must take their first RMD. The way the rules work, if the IRA owner died before his RBD, as the husband did, then his widow would not be required to take an RMD for the year. She can roll over the entire inherited IRA to her own IRA. She will not be required to take RMDs from her IRA until she reaches the year she turns 70 ½.

3.

The Slott Report article (dated April 14, 2016) indicates that Form 8606 “must” be filed when one converts a traditional IRA to a Roth. 

Two questions: (1) What’s the source for this statement in the April 14, 2016 article: “If you are required to file Form 8606, but do not do so, you must pay a $50 penalty, unless you can show reasonable cause”?  So far, I haven’t found anything bearing on this in the instructions for Form 8606.  I’m interested in whether there are any nuances and, in any event, what might be considered reasonable cause?

(2) If the penalty applies, does it matter how long ago the failure to file occurred, or is the penalty the same regardless?

Thanks for anything you can tell me.

GKG

Answer:
Yes. Your assumption is correct. If you convert all or part of your IRA to a traditional IRA, you are required to file Form 8606 for the year of the conversion.

As to your first question, there is always lots of fine print in the instructions to IRS forms and Form 8606 is no exception. You will find the warning on page 6 of the instructions that there is a penalty of $50 for not filing the form, “unless you can show reasonable cause.” Reasonable cause would be determined by the IRS.

The bottom line is if you failed to file Form 8606, you will probably want to go ahead and file the form. The Form 8606 can be filed by itself, as it is a “stand alone” IRS form that provides a signature and date line. The $50 penalty does not include an expiration date. Your best bet is to discuss your situation with your tax advisor.