Beneficiary designations for Roth IRAs, Pt. 1
By Jason Kestler
Kestler Financial Group, Inc.
When you establish a Roth IRA, you're generally required to complete a beneficiary designation form with your Roth IRA custodian or trustee. The beneficiary (or beneficiaries) you name will receive the remaining funds in your Roth IRA after you die. Although choosing a beneficiary may seem straightforward, there are actually several tax and nontax points to consider — and the beneficiary decisions you make now may have significant consequences in the future.
Whether you have a Roth IRA or a traditional IRA, your primary goal should be to choose beneficiaries for whom you want to provide. Because Roth IRAs are different than traditional IRAs, though, the considerations for choosing beneficiaries may differ. Unlike traditional IRAs, Roth IRAs are not subject to the lifetime required minimum distribution (RMD) rules. In addition, qualified distributions paid to your Roth IRA beneficiaries are free from income tax.
Tip: It's important for your beneficiaries to receive professional tax advice as soon as practical after your death so that they may be informed of all of the options available to them and apprised of the time limits for making beneficiary-related decisions. You should also seek professional advice before making a Roth IRA beneficiary designation, because there may be income tax and estate tax consequences associated with your choice.
You don't have to take required minimum distributions from a Roth IRA during your lifetime
If you have a traditional IRA, federal law generally requires that you begin taking annual RMDs from your account by April 1 of the calendar year following the calendar year in which you reach age 70½ (your "required beginning date"). In some limited cases, your choice of beneficiary can affect the way these RMDs are calculated.
By contrast, Roth IRAs are not subject to the RMD rules while you're alive. Consequently, if you don't need income from your Roth IRA, or if you want to preserve the funds for your beneficiaries, you don't have to take distributions from your Roth IRA during your lifetime. If you do choose to take distributions, you need not follow a set schedule--you're free to withdraw as much (or as little) as you like, regardless of the beneficiaries you have named for your Roth IRA. With a Roth IRA, your choice of beneficiary has no impact on the distributions you take (or decide not to take) while you're alive. Qualified Roth IRA distributions are free from income tax
Unlike traditional IRAs, certain distributions from Roth IRAs may be completely free from income tax. To be free from federal income tax, a Roth IRA distribution must be considered a qualified distribution. A distribution is qualified if a five-year holding period has been satisfied, and if at least one of the following also applies:
- You've reached age 59½ at the time of the distribution
- The distribution is made because of a qualifying disability
- The distribution is made to pay qualifying first-time homebuyer expenses ($10,000 lifetime limit)
- The distribution is made to your beneficiary or estate after your death
For instance, if you made your first Roth IRA contribution on April 15, 2006 (for the 2005 tax year), your contribution is treated as having been made on January 1, 2005, for purposes of the five-year rule. Distributions made on or after January 1, 2010, therefore, are considered qualified distributions. (That's because they weren't made within the five-year period of January 1, 2005 to December 31, 2009.) As long as your beneficiary doesn't take distributions from the inherited Roth IRA until after the five-year period has passed, the distributions will escape federal income taxation.
Tip: A single five-year holding period applies to all Roth IRAs you own. You don't determine a separate five-year holding period for each Roth IRA.
Caution: A surviving spouse who treats a deceased spouse's Roth IRA as his or her own must independently satisfy the criteria for a qualified distribution. That is, the distribution must satisfy the five-year rule (see technical note below), and must be made either after the surviving spouse (not the deceased spouse) attains age 59½, dies, becomes disabled or incurs qualifying first-time homebuyer expenses. Technical Note: A surviving spouse who treats a deceased spouse's Roth IRA as his or her own gets to use the earlier of the deceased spouse's Roth IRA contribution date or his or her own Roth IRA contribution date in determining the starting point of the five-year holding period, for both the inherited Roth IRA and any other Roth IRA the surviving spouse owns. See Treas. Reg. Section 1.408A-6, A-7(b).
Nonqualified distributions may (or may not) be taxable
If a beneficiary takes a distribution within the five-year holding period, the distribution is considered a nonqualified one. Special rules determine how nonqualified distributions are taxed (or not taxed) for federal income tax purposes. Because Roth IRAs are generally funded with after-tax contributions, the portion of a distribution that represents your contributions to the Roth IRA is never taxable. However, the investment earnings portion of a nonqualified distribution is subject to income tax.
Roth IRA distributions are considered to consist of contributions first and earnings last. If a beneficiary must take nonqualified distributions, therefore, he or she can withdraw all of your contributions tax free before tapping into the taxable earnings (it gets more complicated if you've converted a traditional IRA into a Roth IRA).
Example(s): Bob contributed $3,000 to his first Roth IRA in 2005 for the 2005 tax year. In 2006, he contributes another $3,000 for the 2006 tax year. Bob dies in 2007. The Roth IRA will pass to the designated beneficiary of Bob's Roth IRA, Bob's brother Al. If Al takes a $3,000 distribution from the Roth IRA in 2007, it will not be a qualified distribution since the five-year period does not end until December 31, 2009 (January 1, 2005 through December 31, 2009). However, even though it will not be a qualified distribution, Al's $3,000 distribution will be considered to consist of Bob's contributions and will therefore not be taxable. Because Bob will have contributed a total of $6,000 before his death, Al will be able to take another $3,000 distribution within the five-year period and still owe no federal income tax. Any amount distributed on or after January 1, 2010, including earnings, will be considered a qualified distribution and will be free from income tax.
Tip: The federal 10 percent premature distribution tax that may apply to premature Roth IRA distributions (i.e., nonqualified distributions taken before age 59½) does not apply to post-death distributions, regardless of your beneficiary's age or your age at the time of your death. Your beneficiaries must take timely post-death distributions from the Roth IRA to avoid penalties
Although you aren't required to take lifetime distributions from your Roth IRA, the beneficiaries of your IRA will generally be required to take RMDs from the account after you die. The distribution methods available to your beneficiaries are similar to the options available to traditional IRA beneficiaries (using the rules that apply for deaths prior to the taxpayer's required beginning date). Note that special rules apply to surviving spouses who are beneficiaries.
Your non-spousal beneficiaries will have to take post-death distributions according to one of the following methods:
- The life expectancy method
- The five-year rule
Caution: The Worker, Retiree, and Employer Recovery Act of 2008 waives required minimum distributions for the 2009 calendar year.
Life expectancy method
A designated beneficiary can generally take distributions over his or her remaining single life expectancy, beginning no later than December 31 of the year following the year of your death. If there is more than one designated beneficiary, the age of the oldest beneficiary (i.e., the one with the shortest life expectancy) must be used to calculate the distributions. Exception: If separate accounts are established for each beneficiary, distributions will be calculated separately for each account.
A designated beneficiary can generally take distributions according to the five-year rule. Under this method, distributions are taken over a five-year period ending on December 31 of the year during which the fifth anniversary of your death occurs. The beneficiary has discretion over the timing and amount of distributions, as long as all of the funds are distributed within the applicable five-year period.
Caution: Because RMDs are waived for 2009, the five-year period is determined without regard to calendar year 2009. For example, if the Roth IRA owner died in 2007, the five-year period ends on December 31, 2013, instead of December 31, 2012.
Four critical dates for taking action
When planning for post-death distributions, your beneficiaries must pay particular attention to four dates: (1) nine months after your death, (2) September 30 of the year following the year of your death, (3) October 31 of the year following the year of your death, and (4) December 31 of the year following the year of your death. Each of these dates may have a tax decision or requirement associated with it.
To be valid, a disclaimer (refusal to accept benefits) must be signed by a beneficiary and meet other requirements no later than nine months after your death. Therefore, even though the designated beneficiaries are determined on September 30 of the year following the year of your death, a disclaimer may need to be signed much earlier to meet the nine months after death rule. If a beneficiary makes such a valid disclaimer, the IRA funds will generally pass to any other primary beneficiary/ies or to the designated contingent beneficiary (if there is one).
September 30 of the year following your death is the day to finalize who are the "designated beneficiaries." The 2002 final IRS RMD regulations mandate that IRA beneficiary designations are final as of September 30 of the year following the year of your death. Only beneficiaries remaining on that date will be included when determining post-death distributions from the Roth IRA.
October 31 of the year following the year of your death is the deadline for furnishing documentation relating to a trust as a beneficiary.
If the life expectancy method is selected, distributions must begin by December 31 of the year following the year of your death. If the distributions don't begin by that date, your beneficiaries can't use the life expectancy method, and the five-year rule becomes the default payout method.
Caution: Although the date for finalizing beneficiaries for distribution purposes is September 30 of the year following the year of your death, an IRA or plan account can be split into separate accounts up until December 31 of that same year. If separate accounts are established, each account is treated separately for purposes of determining post-death distributions. Due to the inconsistency between the September 30 and December 31 dates, it may be advisable to create separate accounts by September 30 rather than waiting until December 31. The rules governing separate accounts are complex. For more information, consult a tax professional.
Click here to read Beneficiary designations for Roth IRAs, Pt. 2.