Inheriting money may be a bittersweet gift because of the personal loss attached to your financial gain. But you’ll likely want to find the best investment vehicle for your inheritance money, whether you’re saving for a short-term purchase or you’re tucking funds away for retirement. If your eyes are on the retirement prize, you may be considering a Roth IRA for your inheritance funds.
If you inherit cash, you won’t be able to contribute those funds to a Roth IRA. But if you inherit money in the form of your spouse’s established Roth IRA, your options include contributing the funds to your own Roth IRA. If you inherit a Roth IRA from someone other than your spouse, you still have numerous options for investing your inheritance money in an IRA if you don’t take a lump-sum withdrawal (also called a distribution).
What Is a Roth IRA?
A Roth IRA puts somewhat of a reverse spin on a traditional IRA in the way that it’s taxed. Both types of these IRAs help taxpayers save for retirement; both have different eligibility, contribution and withdrawal requirements; and both are subject to income tax. A traditional IRA lets you make tax-deferred contributions – you tuck away money without having to pay income tax on it, and you’ll owe income tax only when you withdraw your funds. But a Roth IRA allows you to withdraw your money tax-free, because you pay income tax on the funds before you contribute them to your account.
Why Is Inheritance Money Ineligible?
The IRS allows you to contribute eligible amounts of your earned income to your Roth IRA, but not your unearned income. For example, you can contribute money you’ve earned from the work you do to a Roth IRA (such as wages, salaries and self-employed income). And even though inheritance money is a form of income, you did not “earn” it, which means you cannot contribute it to your Roth IRA. Likewise, other types of unearned income are also ineligible to fund your Roth IRA such as pensions, interest and dividends. (You can, however, contribute alimony or separate maintenance payments to a Roth IRA, even though these are unearned income sources.)
Inheritance Roth IRA for Beneficiaries
If you inherit cash, you can’t contribute the money to a Roth IRA. But you can actually inherit an existing Roth IRA as the account's beneficiary, which carries no inheritance tax when you receive qualified distributions. Withdrawal rules vary, depending on whether you inherit the Roth IRA from your spouse or from someone else.
If You Inherit A Spouse's Roth
If you are the beneficiary of your spouse’s Roth IRA – whether you’re the sole beneficiary or you share this inherited account with other beneficiaries – you have four options for receiving the money. Only one of these options allows you to contribute the funds in your spouse’s Roth IRA to a new Roth IRA (or transfer the funds to your own existing Roth IRA).
- Spousal transfer. This is the only option that gives you the choice to contribute your inherited funds to another Roth IRA. You can open a new Roth IRA and transfer your spouse’s Roth IRA funds into your new account, or you can move your spouse’s Roth IRA funds into your existing Roth IRA account. The money your spouse contributed to the Roth IRA you inherited is available to you at any time. But if you withdraw any of the earnings – the interest earned on the account – before you’re 59 1/2 and before you’ve had the Roth IRA for a five-year holding period, you’ll typically owe taxes on these earnings. (Note: You’ll have to be the sole beneficiary of your spouse’s Roth IRA to take advantage of the spousal transfer. If you’re among other beneficiaries, you’ll have to choose among the other three alternatives.)
- Open an inherited IRA (life expectancy method). With this method, you can open another type of IRA in your name – an “inherited” IRA – and transfer the funds from your spouse’s Roth IRA into this new account. The money is available to you either when your spouse would have reached age 70 1/2 or on Dec. 31 of the year that follows the year of your spouse’s death. These funds are spread over your life expectancy, but if you’re only one of multiple beneficiaries on your spouse’s Roth IRA, each beneficiary must set up an individual account by Dec. 31 of the year that follows the year of your spouse’s death. If the beneficiaries do not establish their individual accounts by this date, the periodic payments you receive will be based on the life expectancy of the oldest beneficiary.
- Open an inherited IRA (5-year method). With this method, you can open an inherited IRA and transfer the funds from your spouse’s Roth IRA into this account. The money is available to you any time over the next five years, specifically by Dec. 31 of the fifth year after the year when your spouse died. If your spouse held the Roth IRA for at least five years, you can receive tax-free payments from your inherited IRA at any time. If your spouse held the Roth IRA for less than five years, you'll be able to withdraw any contributions that were made to the account, tax-free. But if you withdraw any of the earnings (interest), you’ll pay taxes on the amount of earnings you withdraw.
- Receive a lump sum distribution. If you prefer to receive a lump-sum payment of your spouse’s Roth IRA funds, you can choose this method. But if your spouse’s account is less than five years old, you’ll be taxed on the earnings portion of the Roth IRA (the interest earned, not your spouse’s actual contributions).
If You Inherit a Non-Spousal Roth
You can also inherit a Roth IRA from someone who is not your spouse such as other family members and friends. If you receive a non-spousal Roth IRA inheritance, you’ll have three options for receiving your funds.
- Open an inherited IRA (life expectancy method). By opening an inherited IRA in your name and transferring the funds from your Roth IRA inheritance into this new account, you’ll receive periodic payments over your anticipated life expectancy. These payments, called required minimum distributions, are mandatory and must begin no later than Dec. 31 after the year of the Roth IRA holder’s death. If you’re only one of multiple beneficiaries on the Roth IRA you inherited, each beneficiary must set up an individual account by Dec. 31 of the year that follows the year of the Roth IRA holder’s death. If the beneficiaries do not establish their individual accounts by this date, the periodic payments you receive will be based on the life expectancy of the oldest beneficiary.
- Open an inherited IRA (5-year method). Choosing the 5-year option means you must first transfer your inherited Roth IRA funds into an inherited IRA that’s opened in your name. You’ll be able to receive your payments over a 5-year period, which ends on December 31 in the fifth year after the Roth IRA holder’s death. If the Roth IRA holder held his account for less than five years, you’ll be able to withdraw any contributions that were made to the account, tax-free. It’s only if you withdraw any of the interest that the account earned that you’ll have to pay taxes on the amount of the earnings you withdraw.
- Receive a lump sum distribution. If you simply want to cash out your inherited Roth IRA, you’ll receive all the contributions that were made to the account, tax-free. If the Roth IRA account holder had his Roth IRA for at least five years, you’ll also receive any interest tax-free. But if the account holder had his Roth IRA for less than five years, you’ll only owe tax on the interest the account earned.
Victoria Lee Blackstone was formerly with Freddie Mac’s mortgage acquisition department, where she funded multi-million-dollar loan pools for primary lending institutions, worked on a mortgage fraud task force and wrote the convertible ARM section of the company’s policies and procedures manual. Currently, Blackstone is a professional writer with expertise in the fields of mortgage, finance, budgeting and tax. She is the author of more than 2,000 published works for newspapers, magazines, online publications and individual clients.