Inherited Roth IRA

Understanding the Tax Ramifications of an Inherited Roth IRA

A common misconception of an inherited Roth IRA is that upon the account holder’s death, his or her beneficiaries do not need to pay any taxes on the inherited retirement account. This is far from the truth – although an inherited Roth IRA will sidestep income taxes, it is not exempt from estate taxes. Other rules such as early death and withdrawal can complicate matters further. This article will outline the tax ramifications of an inherited Roth IRA.

Estate Tax
If a Roth IRA is included in an estate valued under the taxable inheritance minimum, which as of Tax Year 2020 was approximately $11.5 million, no estate tax needs to be paid.

The traditional solution for married households with combined assets exceeding the taxable inheritance minimum, but lower than double the minimum, is the AB trust.

In an AB trust, the first deceased spouse’s assets (including the Roth IRA) pass not onto the other spouse, but into an irrevocable trust, called an AB trust, which cannot be taxed unless it exceeds the taxable inheritance minimum. When the second spouse dies, the same occurs, without taxation. Therefore, the couple’s assets are passed into the AB trust, a half at a time, to avoid exceeding the taxable inheritance minimum. This would avoid all estate taxes and allow the beneficiaries to be paid directly from the AB trust. For 2011-2012, however, a special extension to the estate tax was created, which grants couples with a combined estate of $10 million to transfer between spouses without being taxed, thus avoiding the AB trust altogether.

In addition, spouses may continue to contribute to the inherited Roth IRA or merge it with their own Roth IRAs. By doing this, however, the surviving spouse will not be able to withdrawal the earnings tax free until he or she reaches age 59 and a half.

The Roth IRA could also be transferred into a foreign trust to avoid domestic taxes, from which the beneficiaries could withdrawal the inheritance.

Another solution requires long-term planning, which divides other assets, such as real estate, equities and cash savings among other beneficiaries prior to death, which can be effective as long as the Roth IRA is not worth more than the taxable inheritance minimum.