Dear Carrie,
I inherited a traditional IRA from my father. Should I convert it to a Roth IRA?
-- A Reader
Dear Reader,
As I'm sure you know, an inheritance can bring up conflicting emotions, placing the positive of financial gain against the sadness of losing a loved one. Complicating the situation further, certain inheritances -- such as an IRA -- are more difficult to sort out than others.
The first thing to understand is that IRA inheritance rules differ depending on whether the beneficiary is a spouse or non-spouse. A spouse has almost limitless options, including treating an inherited IRA as his or her own, even to the extent of converting it to a Roth.
A non-spouse beneficiary such as yourself, however, has much more limited choices. As a non-spouse, you can either take the IRA money in a lump sum or as mandatory withdrawals over time. Unfortunately though, a non-spouse beneficiary cannot roll over any amounts into or out of an inherited IRA -- so the short answer is no, you can't convert the traditional IRA you inherited from your father into a Roth.
However, you can make choices as to how you take the withdrawals, which will have some bearing on your tax situation. Let's review your choices.
If you take the assets as a lump sum
As I mentioned, a non-spouse can take the assets all at once. The upside is that you have access to all the money right away, and there's no 10 percent penalty for early withdrawals. The downside is that you'll have to pay income tax on the distribution at your ordinary income tax rate, which could be quite a sum depending on the amount of the inheritance.
Another concern is that the distribution itself could bump you into a higher tax bracket, increasing the amount of taxes you have to pay. So a lump sum may not be the most tax- efficient way to access the assets.
If you take withdrawals over time
Taking mandatory withdrawals over time can ease your tax burden, but the process is a bit more complicated.
The first thing you have to do is open an inherited IRA in the name of the original account holder for your benefit. Just like the original account holder -- in this case, your father -- you won't be taxed on the assets until you take a distribution, so your tax hit is spread out. Again, there's no 10 percent penalty.
And you have potentially one more choice to make depending on whether your father was under or over 70½ when he passed away. The rules are a bit complex, but here, in a nutshell, are your options:
If the original account holder was under 70 ½, there are two methods for taking distributions:
- The Life Expectancy method, in which you must take an annual required minimum distribution (RMD) spread over your own single-life expectancy, based on IRS life-expectancy tables and determined by your age in the calendar year following the year of your father's death. Distributions must begin no later than December 31 of the year after the year of death and will be reevaluated each year. Of course, you can always take more than the RMD if you wish.
- The Five-Year method, which allows you to take distributions of any amount at any time up until December 31 of the fifth year after the year the account holder died, at which time all assets must be fully distributed.
If the original account holder was over 70½, you must use method number one, the Life Expectancy method. The five-year option doesn't apply. And one more thing: With the Life Expectancy method, if the original account holder didn't take an RMD in the year of death, an RMD must be taken from the account by December 31 of the year the original account holder died.
If there's more than one beneficiary
If there are several beneficiaries and you've chosen the Life Expectancy Method, it's important to open separate IRAs for each beneficiary; otherwise, distributions will be based on the life expectancy of the oldest beneficiary.
Looking at the positive
As you can see, there's a lot to think about. I suggest talking to your tax advisor before making a choice. You could also consult IRS Publication 590, which goes into greater detail on all aspects of IRAs.
While the rules are complex, taking mandatory withdrawals does have its benefits. For one, the undistributed assets keep growing tax-free -- which can be a significant boost over time. You can manage the assets according to your own goals and time horizon. And you can name your own IRA beneficiary, potentially one day passing your father's generosity on to your own heirs.
Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."
Read more at http://www.schwab.com/book. You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.
COPYRIGHT 2014 CHARLES SCHWAB & CO., INC. MEMBER SIPC. (0914-6056)
