Q: I know that I never have to take distributions from my Roth IRA. There's no mandatory payout age. But I've heard that the rules are different for a Roth IRA beneficiary. Is that true? My daughter is my beneficiary and I want to leave a note attached to my will, telling her how she has to handle the Roth IRA. -- BD via email
A: That's a very good idea. You're right – the distribution rules are different for beneficiaries.
As you say, a Roth IRA owner never has to take any withdrawals from the account. This is one of the ways a Roth is different from a traditional IRA, which you're required to start emptying after you're 70 and a half. The other big differences: Roth IRA contributions aren't tax-deductible, but withdrawals from the account are tax-free after you're over 59 and a half and have owned it for at least five years.
Okay -- so what are the rules for a Roth IRA beneficiary?
A surviving spouse can become the new owner by rolling the account into a Roth IRA in his or her own name. But all other beneficiaries must start emptying the account. Your daughter will have to take distributions from your Roth IRA when she inherits it.
If she doesn't, tax penalties will devour the account. The penalty for missing a required distribution is 50% of the difference between the amount she takes from the Roth IRA and the amount she's required to withdraw. In other words, if the mandatory annual distribution is $3,000, and she doesn't take any distribution, the penalty is $1,500.
The good news is that her distributions from the Roth IRA, like yours, are income tax-free.
What’s more, if she handles them the right way, she can keep most of the account growing tax-free for years.
A Roth IRA beneficiary who isn't a surviving spouse has two choices:
Her best option is to start taking minimum annual distributions by December 31 of the year after the account owner's death. The distributions are based on the beneficiary's life expectancy. (For how to calculate the right amount, see 'Do IRA Beneficiaries Get Automatic Payouts?' here ).
A young beneficiary who takes minimum annual distributions can greatly increase her inheritance because the balance in the Roth IRA keeps growing tax-free. (What if she needs more money? No problem -- she can always take a bigger withdrawal. There's no maximum annual distribution.)
The alternative option is to empty the entire Roth IRA by the end of the fifth calendar year after your death.
One more tip to mention in that note to your daughter:
When she inherits your Roth IRA, the Internal Revenue Service lets her name a beneficiary of her own to take over the account if she dies prematurely. "Let's say she has decided to take annual distributions over her 25 year life expectancy," says Barry C. Picker, a Brooklyn New York tax accountant. "The IRS lets her name her son as the beneficiary in case she doesn't live for those 25 years. He won't be able to stretch distributions over his own life expectancy. But he'll be able to take distributions over the balance of her 25 years life expectancy."
And a word of warning: Make sure your Roth IRA custodian -- the bank, broker, mutual fund or insurer that holds the account -- lets your beneficiary name a beneficiary as described above. The IRS permits it -- but some IRA custodians don't. If yours is among them, you should transfer your account to a custodian whose rules are more liberal.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.