Learning about non-spouse inherited Roth 401(k)
You may be reading this non-spouse inherited Roth 401(k) article because your parent passed away or a favorite aunt or uncle. Condolences. Clearly you may have mixed emotions regarding your inheritance. The IRS rules are intended to have you use remove the tax advantages of these accounts within ten years. That said, with strategic planning, you can benefit for a lifetime.
What Are Roth 401(k)s?
Roth 401(k)s combine the features of traditional 401(k)s (pre-tax) and Roth IRAs (post-tax). You essentially are inheriting two different accounts. I address handling the traditional 401(k)s (pre-tax savings in Avoid Making Costly Moves With A Non-Spouse Inherited 401(k). The 401(k)comes with tax implications. Each withdrawal adds to your taxable income to be taxed at your marginal income tax backet in the year of withdrawal.
This article focuses on the Roth side of the Roth 401(k). The Roth post-tax feature is technically called a designated Roth account with after-tax dollar savings allowing for both tax-free growth and tax-free withdrawals, provided the account meets specific criteria.
While you are inheriting a retirement account of a loved one, the IRS rules do not treat your inheritance as a retirement account. This is primarily because you must spend the account within ten years.
Key Options for Non-Spouse Inherited Roth 401(k) Beneficiaries
When you inherit a designated Roth account (DRA) as a non-spouse beneficiaries generally have two options:
1. Transfer to an Inherited Roth IRA
This option allows you to maintain the tax-free status of the funds while fulfilling distribution requirements. The account will titled Loved One’s Roth IRA for the benefit of (FBO) You must deplete the account within 10 years of the original owner’s death.
2. Take a Lump-Sum Distribution
While this provides immediate access to funds, it ends tax-free growth. Beware that the account, may have tax consequences if the account had not satisfied the Five-Year Rule.
The Five-Year Rule
If the original account holder had the DRA for less than five years, withdrawals of the earnings (growth) may be subject to taxes. The contributions can be withdrawn tax free. The five-year period continues from the original account holder’s first contribution date. What happens to the earnings in a DRA that had not met the 5-year rule for non-spouse beneficiaries?
If the DRA has not met the 5-year rule, any withdrawals of earnings are treated as follows:
1. Subject to Income Tax: The earnings portion of the distribution will be included in the your taxable income.
2. Penalty-Free for Non-Spouse Beneficiaries: Withdrawals from inherited Roth IRAs, are exempt from the 10% early withdrawal penalty that applies to the original account owner.
Tax Implications and Planning Strategies for Non-Spouse Inherited Roth 401(k)
Inherited Roth 401(k)s provide tax advantages, but knowing the rules is important:
1. Integrate With Your Financial Plan: Coordinate withdrawals with other income sources and tax strategies. The DRA along with the 401(k) can enhance your financial picture. Strategic thinking can help you rethinking your own Roth 401(k) and potentially your IRA and Roth IRA contributions. The monies can also be helpful in retiring debts you may have too.
2. Avoid Taxes: Waiting until the account has satisfied the 5 year rule before making withdrawals, will allow you to enjoy the tax free status intended for a Roth account.
3. Timing Withdrawals: Minimize impact on other financial resources by strategically timing distributions. Be sure to exhaust the account to avoid penalty. The penalty for missing the 10-year distribution rule for inherited IRAs is a 25% excise tax on the amount that should have been withdrawn, meaning you would owe 25% of the missed RMD as a penalty if you fail to distribute the funds within the 10-year period following the original account owner’s death.
Incorporating a Non-Spouse Inherited Roth 401(k)Into Your Financial Planning
Your inherited Roth 401(k)s should be part of a broader financial strategy:
• Designate Your Beneficiaries: As the inherited account is now yours, you get to elect beneficiaries. This will likely be part of the onboarding process when you establish the inherited account with your selected custodian.
• Balance Taxable and Tax-Free Accounts: Use Roth funds strategically alongside, traditional IRA and taxable (subject to capital gains taxes) investments.
• Strategic and Tactical Investing: You may be inheriting an account with an investment strategy that is not best for you. You should evaluate your need for risk and whether you should values align your investment portfolio.
• Consult a Professional: Financial advisors can provide tailored strategies to optimize withdrawals and tax advantages. Consult a Certified Financial Planner or other retirement designated professional. As the series shows, Inherited retirement accounts are subject to complex rules. A Certified Financial Planner or other retirement designated professional can help you navigate your options and make decisions that align with your overall financial plan.
Final Thoughts on Non-Spouse Inherited Roth 401(k)s
Inheriting a Roth 401(k) as a non-spouse inherited Roth 401(k) beneficiary offers significant advantages. By understanding the rules, you can make strategic decisions that preserve tax-free growth for up to 10 years while aligning with your financial goals. It is important to consider the differences in the rules between the DRA and the 401(k), which is why I address the 401(k) separately. The 401(k) potentially has a greater tax consequence than the DRA. Whether you’re managing wealth for your future or securing your family’s legacy, an informed approach will help you maximize this inherited financial opportunity.
Resources for More Information
• Retirement plans FAQs on designated Roth accounts
• Ten differences between a Roth IRA and a designated Roth account
Read the full article here