Roth IRA 5-Year Rules and Beneficiary Planning Options Highlight Slott Report Mailbag

The unofficial end of summer comes with the Labor Day weekend…where did time go?  Time does in fact fly, which makes planning for your future today more important. After all, tomorrow will be here before we know it. This week’s Slott Report Mailbag includes questions (and our answers) on the Roth IRA 5-year rules and the best ways to leave an inheritance to younger beneficiaries. 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.


I’ve read your books and now your site. My father-in-law has $200,000 in his traditional IRA all stocks) and his wife has about $40,000 in hers (CD). They are elderly and take required minimum distributions (RMDs). Last year I found out he cashed in an additional $20k of her traditional IRA because he was fed up with the bank it was in! If I’d only know he was going to take extra distribution I would have told him to roll it into Roth IRA.

Anyway, he has plenty of money outside the IRA money and does not need it to live on. We have recently made him to update his beneficiaries. He has two boys so one gets 50%. My husband doesn’t want his share and wants it to pass to our kids directly without have to disavow it so our 2 kids are each listed as 25% per stripes.

I´m trying to get my father-in-law to convert a chunk of his IRA to a Roth this year and another chunk early next year. He is listening so we have decisions to be made as to which stocks, etc.

I´m still confused on the 5-year rule around distributions. He is 81 and if his Roth is less than 5 years old at the time of his death, do the beneficiaries (ages, 22, 25, 50) have to take RMDs the next year or are they not allowed to take yet without penalty?

In one place in the book, it seems like they have to start RMDs and in another place it seems to say there is penalty if take before 5 years is up. Can you please clarify this? The answer may play a part in determining how much he converts to a Roth. My kids could wait the 5 years if necessary. However, my brother-in-law might rather blow it early and lose out on the stretch beauty here.

Thanks for clarifying.

To keep the answer to your question “simple,” I am ignoring several facets of the Roth 5-year rules and am concentrating on only those provisions that apply in this case. All Roth accounts are treated as one account of the Roth owner or the individual Roth beneficiary. Roth distributions are deemed to come from annual contributions first (which you don’t have), then from conversions, then from earnings. Distributions of your father-in-law’s (age 81) converted amounts will be income tax free as the tax was paid when the funds were converted. Once all the converted funds are distributed, then earnings will be distributed. If the earnings are distributed before five years are up, then they will be taxable.

The distribution will not be subject to any penalties – your father-in-law is over the age for penalties to be assessed and there is never a penalty on a distribution to a beneficiary. The 5-year period starts on January 1 of the first year your father-in-law establishes a Roth IRA. For example, he does a Roth conversion in October, 2012. The 5-year period starts on January 1, 2012 and any distribution of earnings taken by either the account owner or the beneficiary after January 1, 2017 will be a “qualified” distribution and will not be subject to income tax.

Roth IRAs inherited by non-spouse beneficiaries do have required distributions beginning in the year after the death of the account owner. The beneficiaries do not have the option of waiting until the 5-year period is met. If the beneficiaries take required distributions only, there should be no income tax owed as they will be coming out of the converted amounts until the total amount converted is distributed.


Since I must begin taking my RMDs and I do not need the money, what is the best way that I can leave this money tax free to my children?

One way to leave retirement funds to children is to convert IRA funds to a Roth IRA. There are many things to consider before doing this. The funds converted will be added to your income for the year. They can affect the deductions, credits, phase-outs and exemptions you may be entitled to on your tax return. You could be pushed into a higher tax bracket. Social Security income could become taxable. You might have to pay higher Medicare Part B premiums. You need to have funds to pay the income tax on the converted amount. Those funds should generally not come from the IRA. You will have no required distributions from a Roth IRA, so the account can continue to grow and compound on a tax-free basis. Distributions you take from a Roth IRA will not be added to your income and could reduce your exposure to the 3.8% surtax that is coming as of January 1, 2013. Paying the income tax on a Roth conversion reduces other assets that could be subject to estate or inheritance taxes at your death.

Another option is to take a distribution from your IRA and use the funds to buy life insurance. If the policy is set up so that you do not own it and the children are the beneficiaries, then the proceeds paid at your death are estate and income tax free.

There are also gifting strategies that you could use. All of these techniques should be discussed with a knowledgeable advisor such as a financial advisor, insurance agent, or attorney.

-By Beverly DeVeny and Jared Trexler


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