Inheriting an individual retirement account can come with a new set of rules, deadlines, and tax considerations. One question beneficiaries may have is whether an inherited IRA can be converted to a Roth IRA to take advantage of the Roth account’s potential for tax-free qualified distributions.
The short answer is: it depends on your relationship to the original account owner. A surviving spouse generally has options that are not available to non-spouse beneficiaries. Understanding this distinction—as well as the distribution rules that apply to inherited traditional IRAs and inherited Roth IRAs—is an important first step.
What’s Possible when Trying to Convert an Inherited IRA to a Roth IRA?
Generally, a non-spouse beneficiary cannot convert an inherited traditional IRA to a Roth IRA. IRS rules state that when you inherit a traditional IRA from someone other than your spouse, you cannot treat the inherited account as your own, make IRA contributions to it, or roll amounts into or out of it.
A surviving spouse has different options. Depending on the circumstances, a surviving spouse may be able to treat the inherited traditional IRA as their own IRA or roll eligible inherited assets into their own traditional IRA. Once the assets are held in the spouse’s own traditional IRA, the normal rules for a Roth IRA conversion can apply.
This distinction makes the beneficiary’s relationship to the original account owner especially important.
Source: IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs)
How is an Inherited Roth IRA unique?
An inherited Roth IRA is a Roth account received by a beneficiary following the original owner’s death. It is not the result of the beneficiary performing a Roth conversion on an inherited traditional IRA.
Roth IRAs are generally funded with after-tax dollars rather than pre-tax dollars. Although the original Roth IRA owner is not required to take required minimum distributions during their lifetime, beneficiaries are subject to distribution rules after the owner’s death.
According to the IRS, withdrawals of contributions from an inherited Roth IRA are tax-free, and most withdrawals of earnings are also tax-free. Earnings may be subject to income tax if the Roth IRA had not satisfied the applicable five-year period.
Source: IRS, Retirement Topics – Beneficiary
What is a Roth Conversion?
A Roth conversion moves eligible pre-tax retirement assets from a traditional IRA into a Roth IRA, generally creating taxable income for the year of conversion.
For an IRA owner who is eligible to complete a conversion, the IRS allows a traditional IRA to be converted to a Roth IRA through methods that include a trustee-to-trustee transfer, same-trustee transfer, or eligible rollover.
The untaxed portion of the converted amount generally becomes taxable income for the year of the Roth conversion. That means a Roth IRA conversion can affect:
- Taxable income
- Federal tax liability
- The individual’s tax bracket
- The tax rate applied to income
- Other elements of tax planning
Unlike annual Roth IRA contributions, Roth conversions are not subject to the same income limits that determine eligibility for direct Roth IRA contributions. However, the tax consequences of a conversion can vary considerably by individual circumstances.
Source: IRS, Retirement Plans FAQs Regarding IRAs
Can a Surviving Spouse Convert an Inherited Traditional IRA?
A surviving spouse may have a path to a Roth conversion because the IRS allows spouses to treat certain inherited IRA assets as their own.
If you inherit a traditional IRA from your spouse, IRS rules generally provide options that may include treating the IRA as your own or rolling eligible assets into your own IRA. Once the assets become part of your own traditional IRA, they are generally subject to the same Roth conversion rules as your other eligible traditional IRA assets.
The converted amount attributable to previously untaxed assets generally becomes part of taxable income for that year.
A spouse should also be aware that required minimum distributions cannot be rolled over. The timing of a rollover, RMDs, and a potential Roth IRA conversion can therefore matter.
Source: IRS Publication 590-A and IRS Publication 590-B
Can Non-Spouse Beneficiaries Convert an Inherited Traditional IRA?
No. Under current IRS rules, a non-spouse beneficiary generally cannot convert an inherited traditional IRA into a Roth IRA.
A non-spouse beneficiary cannot:
- Treat the inherited IRA as their own IRA
- Make annual IRA contributions to the inherited account
- Roll amounts into or out of the inherited IRA
- Convert the inherited traditional IRA into their own Roth IRA
A trustee-to-trustee transfer to another properly titled inherited IRA may be permitted. However, the receiving account must remain an inherited account maintained in the name of the deceased IRA owner for the benefit of the beneficiary.
This is one of the most important restrictions to understand when comparing the rules for spousal beneficiaries and non-spouse beneficiaries.
Source: IRS Publication 590-A and IRS Publication 590-B
What Required Minimum Distribution Rules Apply to an Inherited IRA?
Inherited IRAs are generally subject to distribution requirements, although the exact RMD rules depend on the beneficiary and the circumstances of the inheritance.
The SECURE Act changed many of the rules for retirement accounts inherited after 2019. Under current rules, many designated beneficiaries who are not eligible designated beneficiaries must fully distribute an inherited account by December 31 of the year containing the 10th anniversary of the original account owner’s death.
Eligible designated beneficiaries receive different treatment under the rules. The IRS identifies this group as including:
- A surviving spouse
- A minor child of the deceased account holder
- A disabled individual
- A chronically ill individual
- An individual who is not more than 10 years younger than the original IRA owner or retirement plan participant
Whether annual required minimum distributions must also be taken during the 10-year period can depend on circumstances such as whether the original IRA owner died before or after their required beginning date.
These rules replaced what was sometimes referred to as the “stretch IRA” approach for many beneficiaries.
Source: IRS Publication 590-B and IRS, Retirement Topics – Beneficiary
What Are the Potential Tax Considerations of a Roth IRA Conversion?
For an eligible IRA owner, a Roth conversion generally requires previously untaxed amounts to be included in taxable income for the year of conversion.
For example, converting a significant amount of pre-tax assets at once could increase taxable income and potentially place the account holder in a higher tax bracket. The conversion could therefore create an immediate federal income tax liability even though qualified withdrawals from the Roth IRA may later be tax-free.
Some key terms to understand include:
- Pre-tax assets: Retirement assets on which income tax generally has not yet been paid.
- After-tax assets: Funds on which applicable income tax has already been paid.
- Converted amount: The amount transferred from an eligible traditional IRA or other eligible retirement account into a Roth IRA.
- Qualified distributions: Roth IRA withdrawals that satisfy applicable IRS requirements and can generally be received tax-free.
- Tax-deferred: A tax treatment in which applicable taxes are generally postponed until a later distribution.
- Tax-free withdrawals: Distributions that meet applicable requirements and are not included in taxable income.
Because individual tax circumstances differ, a financial advisor, tax advisor, or other tax professional can provide information specific to an individual’s tax situation.
Does a Roth Conversion Eliminate RMDs?
For an individual’s own Roth IRA, the original account owner generally does not have required minimum distributions during their lifetime. Inherited Roth IRAs are different.
After the Roth IRA owner dies, beneficiaries generally become subject to inherited IRA distribution rules. This means an inherited Roth IRA may still need to be fully distributed within a specified period even when the distributions themselves qualify for tax-free treatment.
In other words, “tax-free” does not necessarily mean “no distribution requirements.”
Source: IRS Publication 590-B and IRS, Retirement Topics – Beneficiary
Are Roth Conversions Subject to Roth IRA Contribution Limits?
No. A Roth conversion is different from an annual Roth IRA contribution, and the annual contribution limits do not determine how much an eligible IRA owner may convert.
Annual Roth IRA contributions have eligibility requirements and income limits. Contributions are made with after-tax dollars and do not provide a tax deduction.
A Roth conversion, by contrast, moves eligible assets from another retirement account into a Roth IRA. Previously untaxed amounts included in the conversion generally become taxable income.
Understanding the difference between contributions and conversions is important when reviewing the rules associated with each type of IRA.
Source: IRS Publication 590-A
How Can Mainstar Trust Support Your Inherited IRA?
An inherited IRA can allow eligible retirement assets to remain within a tax-advantaged retirement account for as long as applicable federal rules permit. Mainstar Trust can provide the account documentation and custodial services needed to establish and maintain your account while you remain responsible for directing the account.
When you’re ready to set up your account, reach out to the Mainstar Trust team to learn more about opening an Inherited IRA or Roth IRA and the custodial services available to you.