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Thursday, March 3, 2011

Taxes on inherited Roth IRAs

Taxes on Roth Individual Retirement Accounts (IRA's) can be minimized and/or avoided if certain tax rules are heeded with financial caution and prudence. This article will discuss the taxation of inherited Roth IRA's, and some of the scenarios in which Roth IRA's might be taxed after inheritance. Roth IRA's are a retirement savings instrument that might be best considered as part of an overall retirement plan so as to maintain federal insurance of retirement funds,minimize taxation during life and after life in the case of inherited Roth IRA's and in the diversification of assets for purposes of risk management. The following instructional video explains what happens and what is required when a Roth IRA is inherited:

Taxes on inherited Roth IRAs

When faced with inheritance, the beneficiaries may be exposed to three to four types of taxes, specifically, estate tax, federal and state income tax and possibly property tax on inherited property. Estate tax determines how much of the deceased's income will be taxed before distribution, then federal income tax follows, with state income tax after that. For example, if estate tax charges 48% of the estate's value, the taxable income from the estate is the value after estate tax is deducted. 

In some cases, estate and income tax combined can end up costing a beneficiary near half of the inheritance. In the case of Roth IRA's, the insured amount is only $250,000 for a single Roth IRA, so it might be imprudent to have a Roth with a value above this amount. If however, the value of the Roth IRA is higher than this amount, the following hypothetical example illustrates how it might be taxed with close to maximum estate tax rates.

1) Roth IRA value $5 million (subject to estate tax for amount of $3.5 million in 2009) 2) Tax equals $555,800 + 45%=$555,800 3) $555,800+ 45% x ($944,200)=$555,800+$444,890=$980,690 4) $3.5Million -$980,690=$2,519,310

How to minimize or avoid estate tax on Roth IRAs

To avoid the estate tax on inherited Roth IRA's the deceased can do a number of things prior to dying, as can the beneficiaries of the deceased. First, if the Roth IRA is included in an estate valued under the taxable inheritance minimum, estate tax may not be charged on the Roth IRA's value. Second, the Roth IRA can be part of an AB trust in which ownership of the trust is not assumed by the beneficiaries at the time of death. Other options include better tax planning several years prior to dying so that asset growth is less likely to be subject to high taxes.

• Place the Roth IRA in an AB trust before dying
• Ensure the value of the estate is below the minimum taxable amount
• Reallocate Roth funds into non-taxable instrument prior to death
• Transfer ownership of the Roth IRA to a foreign owned Trust company

Roth IRA's are useful financial instruments for avoiding income tax but not estate tax. (investmentguide.com) Thus, if an estate is worth over the taxable benchmark set by the government for that year, for example $3 million, then that value is taxed if it includes a Roth IRA. For this reason it can be important to know which assets and financial instruments are not included in the estate value calculation.

Moreover, being aware of what methods exist for lowering potential tax on inherited Roth IRA's can also be important. For example, in some instances, trusts such as AB trusts are not taxable following the death of the primary trustee. It may be unlikely that a Roth IRA would be subject to estate tax regardless of their ability to avoid this tax because Roth IRA's are only insured up to $250, 000.00. For this reason, controlling the size of the Roth IRA and hedging against taxes through tax protected investment vehicles such as insurance policies or non-taxable bonds may be a good idea.


1. http://www.irs.gov/pub/irs-pdf/p590.pdf
2. http://tinyurl.com/64rgbz2
3. http://fsc.fsonline.com/fsj/archive/2004est.html
4. http://rothiraexplained.com/fdic-insurance-coverage-for-iras.html
5. http://www.schwab.com/public/file?cmsid=P-1625576&cv1
6. http://tinyurl.com/6d4qsw7 (Expired reference link)