The benefits of a Roth IRA are legendary, but the benefits of an inherited Roth IRA are even better. One of the best legacies you can leave to your children or grandchildren is an inherited Roth IRA. By leaving a Roth IRA to your beneficiaries, you leave them with the ability to create a stream of tax and penalty free income for their lifetime, regardless of their age when they inherit the account. This is particularly powerful if the beneficiary of the Roth IRA is a young child.
Recently a client of Quest IRA, Inc. opened a couple of Roth IRAs with a relatively small deposit into each. The beneficiary of each Roth IRA was one of his young grandchildren. The client has been a successful real estate investor his whole life, and he has friends who are also real estate investors. The fact that there is not a lot of money in each account does not mean that they cannot be invested successfully. The accounts may combine with other IRA accounts to enter into transactions, or they may be invested separately using real estate investing techniques which do not require a lot of money. While the client is still alive, he will likely invest the Roth IRAs primarily into real estate based assets, since that is what he is most familiar with as an investor. Because the beneficiaries are so young at this time, the client has made arrangements with his real estate investor friends to ensure that the accounts continue to be invested for maximum cash flow and growth for the benefit of his grandchildren after he dies. If the client dies prior to his grandchildren reaching the age of majority, his children will have to set up the inherited Roth IRAs for the benefit of his grandchildren, so their cooperation and understanding is essential to the success of his plans.
What You Need To Know To Set Up A Roth IRA. In order to set up a Roth IRA you (or your spouse if you are married and filing taxes jointly) must have compensation at least in the amount of the contribution, and no more than the maximum Modified Adjusted Gross Income (MAGI). Compensation is generally described as wages, salaries, commissions, tips, self-employment income, taxable alimony or separate maintenance, and non-taxable combat pay. In order to qualify for a direct contribution to a Roth IRA in 2013, the MAGI of single individuals cannot exceed $127,000, and for married couples filing jointly the MAGI limit is $188,000. These limits are adjusted each year. If you have MAGI over the limit and are under age 70½ with compensation, you may still indirectly qualify for a Roth IRA. Under these circumstances you can contribute to a traditional IRA and then convert that IRA to a Roth IRA. There are no longer income limits for converting from a traditional IRA to a Roth IRA. The maximum contribution for 2013 is $5,500 for a person under age 50 and $6,500 for a person who will be age 50 or older by the end of the year.
Unlike a traditional IRA, there is no age discrimination for contributing to a Roth IRA. Anyone with compensation may contribute to a Roth IRA, including those over age 70 ½. If you do not have any compensation, you may have to create some in order to qualify for a contribution. Often the potential beneficiaries of the Roth IRA or their parents are willing to help you create compensation. Depending on your abilities, this may include anything from consulting services to stuffing envelopes to answering phone calls or otherwise helping in their business. Be sure that your hours worked and the services performed are carefully documented and that your pay is a reasonable wage. Keep in mind that any compensation may cause you to owe additional taxes, depending on your income level. Any self-employment income of $400 or more will be subject to Social Security and Medicare taxes even if you do not owe any income taxes, and you will be required to file a tax return to pay those taxes.
What Happens After The Roth IRA Is Inherited. Although there is no requirement that you as the original Roth IRA owner take Required Minimum Distributions (RMDs) from the account during your lifetime, your beneficiaries will be required to take RMDs beginning in the year after they inherit the account. The good news is that distributions from an inherited Roth IRA never incur the 10% premature distribution penalty, regardless of the age of the person taking the distribution. Even better, if a five year test for qualified distributions is met, the distribution is tax free as well. Creating tax and penalty free income for your beneficiaries is the ultimate goal when setting up a Roth IRA to be inherited.
The five year test for a qualified (tax and penalty free) distribution will be satisfied if, at the time of the distribution, you had a Roth IRA established for your benefit for at least five tax years. For example, if the first Roth IRA you ever had was opened before April 15, 2013 for the tax year of 2012, qualified distributions could begin as early as January 1, 2017. Since you only have one five year test for all of your Roth IRAs, the five year clock begins to run on January 1 of the first tax year for which any Roth IRA is opened for your benefit. The account which is being inherited does not have to separately meet the five year test for qualified distributions.
If you did not have a Roth IRA set up for your benefit for at least five tax years when your beneficiaries take their RMDs, the number of years the inherited Roth IRA has been established is added to the years that you had any Roth IRA set up for your benefit to determine if a distribution is a qualified distribution. For example, if you die after having had a Roth IRA open for only three tax years, the RMDs would not be qualified distributions until your beneficiary had the inherited Roth IRA open for an additional two tax years. Your beneficiary must still take RMDs from the account regardless of whether or not the distributions are qualified distributions. If the account grows in value substantially before the five year test has been met and the RMDs exceed your contributions, a portion of the distribution may be taxable to your beneficiary. This may affect the investment strategy for an inherited Roth IRA, at least until the 5 year test has been met. Your beneficiary should also be aware that no additional money may be contributed to an inherited Roth IRA, so some conservatism in investing the account is justified.
To figure out how much the RMD is each year for an inherited Roth IRA, the first task is to determine the relevant life expectancy factor based on the inherited Roth IRA owner’s age in year following the date of death of the original Roth IRA owner. This factor may be found on the IRS Single Life Expectancy Table, which is Table 1 in Appendix C of IRS Publication 590. You can download all IRS publications from www.irs.gov. Take the value of the account as of December 31 of the prior year and divide it by the life expectancy factor to get the RMD amount. For example, a beneficiary who must begin taking distributions from an inherited Roth IRA at age 10 has a life expectancy factor from the IRS table of 72.8. If the original Roth IRA owner dies in 2013 and balance in the inherited Roth IRA is $1,000 as of December 31, 2013, the first year RMD to be taken in 2014 is calculated as follows:
Prior Year End Balance ($1,000)
Life Expectancy Factor (72.8) = Required Minimum Distribution ($13.74)
In subsequent years the factor is reduced by 1, and in each subsequent year the balance on December 31 of the prior year is divided by the new factor. For example, the life expectancy factor in this scenario is 71.8 in year 2, 70.8 in year 3, and so on. Since the original life expectancy factor in this example was 72.8, after a total of 73 years the inherited Roth IRA must be completely distributed, either to the original beneficiary or to his or her heirs. If the inherited Roth IRA owner prefers, he may choose to take the entire account balance by the end of the fifth year following the death of the original Roth IRA owner. With this choice no RMDs are required at all during the five years, but it does somewhat defeat the purpose of setting up the inherited Roth IRA. A spouse who inherits a Roth IRA has some additional choices which are not discussed in this article.
Leaving a Roth IRA to a young beneficiary means that beneficiary has to take very little money from the account in RMDs in the early years, and the distribution period is much longer. The initial distribution in the above example was only 1.374% of the prior year end account balance. For comparison, if the first distribution was at age 50 the relevant life expectancy factor from the table would be 34.2 and the distribution would be approximately 2.92% of the prior year account balance. To the extent investment earnings in the account exceed the percentage of the account balance that must be taken as an RMD, the account will continue to grow in value, as will the dollar amount of the RMD each year. If your beneficiary needs more than the RMD in any given year they can take a higher amount, but it will not be credited towards RMDs in future years.
The Power Of Self-Direction. The power of an inherited Roth IRA is magnified greatly if the account is self-directed. With a self-directed IRA you can invest in what you know best, which substantially lowers your investment risk and can greatly increase your yield, especially if you are a good investor. There are very few investment restrictions imposed on IRAs by the Internal Revenue Code, but you do have to have a custodian or third party administrator like Quest IRA, Inc. to hold non-traditional assets in your IRA. Popular investments in self-directed IRAs include real estate, promissory notes, options, tax liens, trusts, LLCs, partnership interests, and private stock, among many other choices. Contrary to what you may have heard, your IRA is not locked into only investing in the stock market. This opens up almost endless possibilities for growing your IRA. To learn more about self-directed IRAs, visit www.QuestIRA.com, where you will find a lot of great FREE education.
Setting up a Roth IRA for the benefit of your child or grandchild is a wonderful legacy which can benefit them for a lifetime. You are leaving your beneficiaries with endless possibilities to create tax and penalty free income which is accessible to them at any age in any amount for any reason to meet their needs. You will never make a better investment of your time and money than setting up and funding a Roth IRA for the benefit of your children or grandchildren, then sharing with them your knowledge and skills as an investor. An inherited Roth IRA is truly the gift that keeps on giving. Get started today!
H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney. He is also President of Quest IRA, Inc. (www.QuestIRA.com), a self-directed IRA third party administrator with offices in Houston, Dallas, and Austin, Texas, and in Mason, Michigan. He may be reached by email at Quincy@QuestIRA.com. Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2013 H. Quincy Long. All rights reserved.