Inherit A Roth IRA? Watch Out For Penalties For Missing RMDs
by Peter Rizzo
Roth IRAs and 401(k)s are becoming increasingly popular, especially with Digital currency and private offering investors. The dream of having millions in no taxable accounts is becoming a reality for many. The important issue is, if you inherit one of these accounts, KNOW THE RULES! I came across a great article in Forbes by Julie Jason, JD, LLM, that addresses this. I have taken some excerpts from the article that are pertinent to those who inherit ROTH IRAs.
Roth IRA owners don’t have mandated withdrawal requirements during their lifetimes. But that’s not the case for those who inherit a Roth IRA.
Since Roth IRA withdrawals are not subject to income taxation, you would think that there would be no penalties for failing to take a withdrawal when beneficiaries are required to do so.
However, if the inheritors fail to abide by RMD (required minimum distribution) rules, there is indeed a penalty, called an excise tax.
Keep in mind that you will need a tax adviser to guide you. Tax advice can only be provided on a case-by-case individual basis that applies to your particular situation. Be sure to talk with your tax adviser about IRAs.
Some Roth IRA Basics
Roth IRAs are truly tax-advantaged, outcompeting traditional IRAs by far. Income and gains earned are not subject to taxation while the Roth is open. Nor are they subject to taxation when withdrawals are taken, as long as the Roth IRA in question has a five-year history (five years being measured from the first deposit). Further, the Roth IRA owner is not subject to RMDs during their lifetime.
What Happens When the IRA Owner Dies?
While the Roth IRA owner is not required to withdraw funds during their lifetime, when the owner passes away, the rules change. The beneficiary who inherits the Roth must follow Roth IRA RMD rules.
The beneficiary can wait until the year containing the 10th anniversary of the death of the owner before taking any withdrawals. But then, they need to empty the Roth IRA by Dec. 31st of that 10th year (see Internal Revenue Code section 401(a)(9)(H)(i)(I)).
Different rules apply to spouses and “eligible designated beneficiaries,” including situations where yearly RMDs are required (see Internal Revenue Code section 401(a)(9)(H)(ii)). An EDB is defined in IRS Publication 590-B as an IRA owner’s “surviving spouse, the owner’s minor child, a disabled individual, a chronically ill individual, or any other individual who is not more than 10 years younger than the IRA owner.”
Inherited Roth IRA Penalty?
Considering that Roth IRA withdrawals are not taxable neither to the Roth IRA owner nor to the Roth IRA beneficiary, you may think it odd that a penalty applies if someone who inherits a Roth fails to take RMDs.
To get some insight, I reached out to Ted Ginsburg, director and head of the Compensation and Benefits Tax Practice at Marcum LLP, a national accounting and advisory services firm.
It comes down to regulations.
“The Treasury Regulations which impose the penalty for failure to take a required minimum distribution specify that Roth IRAs are included,” Ginsburg said, citing Treasury Regulation 54.4974-2 at A.2.
The rationale is similar to the policy for requiring a traditional IRA distribution when the RMD age is reached:
“Congress does not want funds accumulating in qualified plans (including IRAs and Roth IRAs) because that would defer taxation on the earnings in those plans as well as the principal of the plans (not the case with Roth IRAs).
“The government wants the funds in those accounts circulating in the economy, instead of merely accumulating for distribution to the descendants/beneficiaries of the account holder,” Ginsburg explained.
New Penalties for 2023
Until tax year 2023, the penalty (excise tax) for an RMD shortfall was 50% of the amount of an RMD that was not taken by the end of the calendar year in question. For example, a failure to take a $50,000 RMD resulted in a penalty of $25,000 under the old rules.
That 50% penalty is now history. SECURE Act 2.0, which was enacted at the end of 2022 as part of the Consolidated Appropriations Act, 2023, reduced the 50% penalty to 25%, and further to 10% in “certain cases.” If you miss an RMD in 2023, this change in the law applies to you (effective beginning in tax years after Dec. 29, 2022).
Again, if you have an Inherited ROTH IRA or are doing estate planning with your ROTH account – see a Tax advisor to plan properly so you get the benefit and not the IRS.