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Under the secure law, Roth IRAs allow beneficiaries to enjoy 10 years of tax-free account growth.
Prior to 2020, leaving a traditional IRA to young beneficiaries provided double tax breaks: the original owner reduced taxable income by making pre-tax contributions during life, and beneficiaries were able to extend tax deferral benefits for life.
Under the Preparing Every Community for (Safe) Retirement Promotion Act, these incentives have been muted by the new ten-year distribution rule for ineligible designated beneficiaries. On the other hand, changes have been made to the security law Roth conversions More attractive to customers looking to make a tax-deductible gift to beneficiaries upon their death.
While a Roth conversion strategy can have many different benefits for the original account owner during life, many clients ignore the potential upside for account beneficiaries after the death of the original account owner.
Rules for distributing an inherited IRA
before Safe law It became law, and beneficiaries of a legacy IRA now have the option to extend the distributions — and associated tax liabilities — from the account over their own life expectancy. The younger beneficiaries have often benefited from decades of tax-deferred growth.
Post-Insurance Act, beneficiaries who do not qualify as “eligible designated beneficiaries,” or EDBs, must empty the account within 10 years. Furthermore, if the original owner has already begun receiving the required minimum distributions, the beneficiary must also take annual RMDs during the 10-year distribution period.
While the IRS provided some relief from annual RMD requirements for the period 2021-2023, a person who inherits a Traditional IRA must now pay taxes on the entire account balance within 10 years of the death of the original account holder. That can be a huge blow, especially if the beneficiary is in the prime of their earning years.
Roth conversions and the ten-year rule
The Secure Act has modified the rules governing inherited Roth IRAs. Roth recipients who are not as good as development bankers are now required to empty the account within the same 10-year distribution period that applies to traditional accounts.
However, Roth IRAs have a distinct advantage because Roth IRAs are not subject to any RMD rules during the life of the original IRA owner. As always, Roth IRA recipients must take out RMDs after the original account holder dies.
The benefit is that the original owner will always be considered dead before the desired start date. This is because a Roth account can never go into a payable state because there is no required start date (that is, because the original owner never had to have lifetime RMDs in the first place).
In other words, any recipient of a Roth IRA can wait until year 10 to empty the account and allow the money to grow tax-free for another 10 years without worrying about the tax that was charged in year 10.
When the beneficiary eventually takes the distributions, the original contributions are not taxable because the original account holder paid taxes on the Roth contributions during life. If the five-year rule is met (i.e., at least five years have passed since the original owner made their first contribution or transferred to the account), the dividends will also be tax- and penalty-free for the beneficiaries.
Roth conversions: the basics
Individuals whose income exceeds the limits applicable to Roth IRAs cannot contribute directly to a Roth account. Instead, they must go through the “back door” by executing transfers.
The individual takes the money contributed before tax into a traditional IRA and performs a transfer to move the money into a Roth account (paying taxes on the amounts transferred at the individual’s ordinary income tax rate).
Assuming the owner leaves the money in the Roth car for at least five years, the amounts transferred and earnings from those amounts can be withdrawn tax-free.
There are ways to reduce the impact of current taxes that prevent some clients from performing Roth conversions. Some customers prefer to transfer small amounts over many years to fund their Roth accounts.
Others wait until they stop working, so they’re in a lower tax bracket. However, with the Trump-era tax cuts for high-income taxpayers currently in effect, clients should pay attention to proposed future tax increases to get the most out of their Roth conversions.
Conclusion
Roth accounts are extremely beneficial to the person funding the account because they provide a tax-free source of income during retirement. However, Roth accounts also provide a valuable, tax-deductible gift for account beneficiaries.
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