If you’ve just inherited an individual retirement account (IRA) from a relative, you might be wondering about doing a Roth conversion. Unfortunately, if you’re not a surviving spouse, you can’t directly convert an inherited traditional IRA into an inherited Roth IRA.
This article will help you understand your options. That way, more of your money ends up in a Roth account and you can take advantage of tax-free growth.
Before the SECURE Act
Prior to the passage of the SECURE Act (Setting Every Community Up For Retirement Enhancement), a non-spouse beneficiary could take advantage of ‘stretch IRA’ rules. While there were required minimum distributions, a beneficiary could stretch those out over their own life expectancy.
The stretch IRA provisions allowed greater flexibility in managing taxable income. As long as a beneficiary withdrew the annual RMDs, he or she could take out more or less, depending on their income level.
In lower income years, a beneficiary could take more money out and still remain in a lower tax bracket. A job layoff would be a perfect example of this.
In turn, would lower the RMD amount in future years. That would allow a beneficiary to avoid creeping into a higher tax bracket later on.
But all that changed with a new tax law called the SECURE Act.
SECURE Act Changes
The SECURE Act introduced three significant changes:
- The elimination of the stretch IRA distribution method.
- Introduction of the 10-year rule for distributions.
- Introduction of a new class of beneficiaries.
What happened to the stretch IRA?
Effective January 1, 2020, the stretch IRA no longer exists for new beneficiaries. If the original account owner died on December 31, 2019 or earlier, then those beneficiaries are still subject to stretch IRA provisions.
If the original IRA owner dies after December 31, 2019, then the distribution rules depend on whether the new account owner is considered an eligible designated beneficiary. But if the new owner is not considered an eligible designated beneficiary, then they’re subject to the 10-year distribution rule.
What is the 10-year distribution rule?
The 10-year rule is pretty straightforward. For all retirement accounts inherited by non-eligible designated beneficiaries after December 31, 2019, all funds must be withdrawn from the inherited account within a 10-year period following the calendar year of the original account owner’s death.
This includes all retirement accounts, such as:
- Any type of IRA (including a SIMPLE IRA and SEP IRAs)
- 401k plans and other ERISA plans (like 403b plans)
- Deferred compensation plans (like 457 plans)
For example, let’s imagine that John Smith passes away on March 31, 2022. His adult son, Eric, is the sole beneficiary.
As a result, Eric inherits John’s entire IRA. Eric has until December 31, 2032 to fully empty the entire account.
The 10-year rule applies unless the beneficiary is either:
- Not an individual. This usually means that the original owner left their estate or a complex trust as a beneficiary. In these cases, a 5-year rule applies, where the account must be empty within 5 years, not ten.
- An eligible designated beneficiary.
There is a provision that allows certain see-through trusts to be treated as designated beneficiaries. A see-through trust would not be subjected to the 5-year rule, as long as the trust:
- Is valid under state law
- Becomes irrevocable upon the death of the retirement account owner
- Contains valid beneficiaries, and
- Submitted to the IRA custodian by October 31 of the year following the date of death. As an alternative, a certified list of trust beneficiaries can be provided to the IRA custodian by the deadline.
What is an eligible designated beneficiary?
The SECURE Act created the term “eligible designated beneficiary” to describe a special class of beneficiary. Eligible designated beneficiaries fall into one of 5 categories:
- Spousal beneficiaries
- Disabled individuals
- Chronically ill individuals
- Child beneficiaries
- Persons not more than 10 years younger than the owner of the IRA.
Surviving spouses are technically eligible designated beneficiaries. However, spouse beneficiaries have a couple of other options not available to other EDBs. So we’ll discuss those options separately.
Inherited IRA Rules For Spousal Beneficiaries
As an eligible designated beneficiary, a surviving spouse can stretch his or her IRA distributions over his or her expected lifetime. In fact, that ‘stretch IRA’ provision exists for all EDBs as if the SECURE Act never existed.
However, there are a couple of other options available only to spouses.
A spouse can roll over part or all of the inherited IRA to their own IRA.
This is the only known instance in which you can convert an inherited IRA into a Roth IRA.
But technically, a surviving spouse would rollover the deceased spouse’s IRA into their own IRA. From there, the spouse would do a Roth IRA conversion into their own Roth IRA.
Of course, the same tax rules apply. These include (but are not limited to) the following:
- For any IRA contributions where the original account owner received a tax deduction on their tax return (pre-tax contributions), taxes are owed on the converted amount.
- If there is a combination of pre-tax contributions and non-deductible contributions, Roth conversions are subject to the pro-rata rule.
- Workplace retirement plans are not subject to the pro-rata rule. A spousal beneficiary can roll an inherited IRA into a workplace retirement plan, if the plan allows it.
- Inherited IRAs are eligible for qualified charitable distributions (QCDs), as long as the account owner is otherwise eligible to make them. In other words, the account owner must be at least 70 ½ in order to make QCDs from their inherited IRA.
A spouse doesn’t have to roll the inherited IRA into their own IRA.
A spousal beneficiary can keep the inherited IRA by itself. But why would this make sense?
Let’s imagine a surviving spouse who is 55 years old, who does a spousal rollover into her own IRA. Since she’s under the age of 59 ½, she cannot take any money back out without paying a 10% early withdrawal penalty, unless she meets one of the other early exception criteria.
But by leaving the money in a separate inherited IRA, she keeps that account available for future penalty-free withdrawals.
A spouse doesn’t have to take RMDs right away.
But they can take distributions if they want to. The spouse can choose either option, depending on which one is more beneficial.
If the surviving spouse is younger, perhaps they are better off rolling the inherited IRA over into their own IRA. And since the SECURE Act changed the RMD age from 70 ½ to 72, the spouse gets a little more time before the required beginning date kicks in.
But let’s imagine the opposite is true, and the surviving spouse is older than the deceased spouse. In that case, they can wait until the original account holder would have turned 72 before starting RMDs from their spouse’s IRA.
Having covered the rules for spousal beneficiaries, let’s take a look at other EDBs.
Inherited IRA Rules For Eligible Designated Beneficiaries
The other 4 classes of EDBs have very similar distribution rules. These distribution rules largely resemble the rules that were in place under the stretch IRA provisions. Let’s take a look at each EDB class and see the rules that apply to each type of beneficiary.
For purposes of the SECURE Act, the definition of ‘disabled individuals’ is found in Internal Revenue Code Section 72(m)7. According to this reference, a disabled individual must be:
“unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof in such form and manner as the Secretary may require.”IRC Section 72(m)7
This is a fairly strict definition of disability. For example, someone who might qualify for Social Security Disability benefits, yet still able to work, probably would not qualify as an EDB under this section.
But if a person were able to meet this definition of disability, then he or she would be able to use the stretch IRA provisions. This would allow them the beneficiary to take their RMDs from their IRA account as calculated using their single life expectancy.
Chronically ill individuals
Chronically ill, as defined by IRC Section 7702B(C)2, is someone who is unable to perform at least 2 of the 6 activities of daily living (ADLs). This is similar to the language used for defining long term care. As a reminder, the 6 ADLs are:
The SECURE Act specifically changes the requirements under subparagraph (A)(i). Instead of requiring a health care professional to certify that a chronically ill individual cannot perform 2 of the 6 ADLs for a period of 90 days, the SECURE Act simply requires that the “period of inactivity be one that is indefinite and reasonably expected to be lengthy in nature.”
Under such conditions, a chronically ill individual would be eligible for stretch IRA treatment.
Child beneficiaries might be the most confusing of the EDB categories.
A child is considered to be an EDB until he or she reaches the “age of majority.” After the child reaches the age of majority, that child is not an EDB unless he or she meets one of the other EDB criteria. From there, that beneficiary would be expected to completely deplete their IRA assets within 10 years.
When the SECURE Act was first published, this presented some confusion, since the age of majority is a state definition. This definition can range from age 18 to 21 (although some states use 25 as a majority age under special circumstances).
However, the IRS has released guidelines establishing 21 as the age of majority. Let’s imagine that Eric is 15 when he inherits John’s IRA.
Eric would be entitled to use stretch provisions (using the single life expectancy method for RMDs) until he reaches the age of 21. From there, he would have 10 years (or until he reaches age 31) to completely empty the account.
Persons not more than 10 years younger than the owner of the IRA.
This might be the most interesting of the EDB definitions.
Anyone who is a designated beneficiary who is not more than 10 years younger than the original IRA owner can use the stretch IRA provisions. This includes:
- Older relatives, like parents, aunts & uncles, or grandparents
- Peer relatives, like cousins and siblings
- Unmarried partners (as long as they are not more than 10 years younger than the original account owner)
Let’s imagine that John’s sister Mary was the beneficiary, and not Eric. As long as Mary is not more than 10 years younger than John, she would be entitled to use the stretch IRA provisions for withdrawals.
Now that we’ve covered EDBs, let’s look at a hidden planning opportunity for people who inherit workplace retirement accounts.
Planning opportunity for people who inherit workplace retirement accounts
If you’ve inherited a traditional workplace retirement plan, like a 401k or 403b, you can always transfer it into an inherited IRA. And here lie some of the financial planning opportunities that could get you similar results to a Roth conversion.
If your inherited retirement plan was a Roth account, then you could simply transfer it into an inherited Roth IRA. This is essentially the same thing as a backdoor Roth conversion. You don’t have to pay taxes, since the original account owner already paid taxes on the money that went into the Roth account.
If your inherited retirement plan was a traditional account, then you can transfer it into an inherited traditional IRA or Roth IRA. When transferring your retirement plan into a traditional IRA, you don’t pay taxes until the money comes out of the IRA account. If you transfer it into a Roth IRA, then you would be responsible for paying taxes on the conversion.
In either case, it’s important to note a few things:
- Regardless of the account type, any non-eligible designated beneficiary has until the end of the tenth year after the original account owner’s death to completely empty the inherited account.
- You can move money from an inherited workplace retirement plan more than once. But this depends on the plan documents and the retirement plan administrator. Before moving forward with anything, you should always talk to the plan administrator so you fully understand your options.
- For pre-tax accounts: any withdrawals of earnings growth is fully taxable. So you may want to talk with your financial advisor on how you might do partial withdrawals over time to stay within a marginal tax rate.
The other ‘Roth conversion’ planning opportunity
Let’s imagine that you’ve been meaning to make IRA contributions each year. But you haven’t, because cash flow is always an issue.
A simple solution would be to take periodic withdrawals from your inherited IRA, then use that money to fund your IRA contributions. Depending on your income level, you might be able to make contributions directly to your Roth IRA.
Unfortunately, unless you’re a surviving spouse, you cannot convert your inherited IRA directly to a Roth account. However, there are numerous financial planning and tax planning opportunities for beneficiaries. And if you qualify as an eligible designated beneficiary under the SECURE Act, you have access to even more options.
After retiring from a 24-year career as a Naval officer in 2017, Forrest became a financial planner to help people achieve success in managing their personal finances. In 2022, he sold his partnership stake in his financial planning firm to focus on helping people full-time through his writing.
Featured in: Forrest’s writing has been featured in the following publications: Forbes, Military.com, NerdWallet, Yahoo Finance, The Military Guide, The Military Wallet, Christian Science Monitor, and many other publications.
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