Can An Inherited IRA Be Converted?
Friday, September 22nd 2023
Be it through inheritance of an Individual Retirement Account (IRA) or estate planning, understanding its rules and the potential conversion possibilities is critical for both. With recent changes brought forth by the Setting Every Community Up for Retirement Enhancement Act of 2019 (1) further complicating matters, this post will delve into whether an inherited IRA can be converted, the rules governing conversion processes and key strategic considerations you need to keep in mind when planning.
An Overview of Inherited IRAs
An Inherited IRA, also referred to as “beneficiary IRA,” arises when someone becomes the beneficiary of an inherited IRA or employer-sponsored retirement plan upon its initial owner’s passing away, with all funds managed, distributed, and taxed accordingly as per IRS guidelines.
An Individual Retirement Account, or IRA, offers two categories of beneficiaries – spouse and non-spouse beneficiaries. Their rights and options differ in many respects – for instance a spouse beneficiary is given the choice to treat an inherited IRA as their own by either renaming it in their name or rolling it over into another IRA account or retirement plan they already hold.
Non-spouse beneficiaries do not enjoy as many options when inheriting money left by an original owner’s death, withdrawing all or taking mandatory distributions based on life expectancy should he or she die before January 1, 2020 (known as the 10-year rule introduced by SECURE Act).
Can an Inherited IRA Be Converted?
Converting an inherited IRA often depends on who its beneficiary is; spouse beneficiaries often have more flexibility for Roth IRA conversion. Once treating it like your own money, treat any funds found within an inherited IRA as your own funds in your traditional IRA – this process is known as Roth IRA conversion.
Contrarily, non-spouse beneficiaries cannot convert an inherited IRA account to a Roth IRA due to the Internal Revenue Service (IRS) regulations limiting conversions only for owners or spouse inheritors who treat the account like it’s theirs.
Roth IRA Conversion: A Deeper Look
Roth IRA conversion refers to the process of moving assets from traditional IRA to Roth IRA accounts, typically paying ordinary income tax on any contributions and earnings that qualify as tax deductible contributions or earnings within that account. Converting can provide potential for tax-free growth as well as withdrawals during retirement if certain criteria are fulfilled; making this strategy ideal for individuals anticipating being in an equal or higher tax bracket after they retire.
As a spouse beneficiary considering a Roth IRA conversion, it’s vital that you carefully consider its tax implications. Converting may increase your taxable income for this year and push you into higher tax brackets; so, to manage this impact more evenly over multiple years it may be worthwhile phasing the conversion over several years.
Establishing and managing an IRA involves careful thought. Below are several strategic points you should keep in mind:
- Consider your options: As the spouse beneficiary of an IRA account, you have various choices available to you: treat it like it were your own account, roll it into an existing IRA or convert to Roth IRA status. Each option presents its own set of advantages and disadvantages depending on your unique personal situation and goals for future savings.
- Consider tax implications: Converting to a Roth IRA may incur tax obligations; to minimize them effectively or mitigate them successfully you should ensure you can afford to cover this bill or have a strategy in place to manage its effects.
- Consult with an expert: Due to their complex nature, inheritable IRAs and conversions require extensive legal consideration, with any misstep resulting in additional taxes and penalties that might incur. Having someone on board who understands these matters as your advisor could prove extremely helpful.
- Understand the SECURE Act: The SECURE Act brought significant modifications to inherited IRA rules for non-spouse beneficiaries, so it’s crucial that you are familiar with how this legislation could impact you.
- Plan for the future: As the original owner of an IRA, think carefully about who your beneficiaries will be when inheriting it and their circumstances when tax season rolls around – especially if this will mean they fall within high tax brackets upon inheriting. In such a situation, considering converting their IRA to Roth during your life may make more financial sense than waiting.
In order to better demonstrate how complex an inherited IRA conversion can be, let us discuss several hypothetical cases:
- Case 1: John is an eligible spouse beneficiary who inherits an inherited IRA for $500,000. Currently in a lower tax bracket but expecting higher brackets down the road, John can convert this traditional IRA to a Roth IRA now to pay taxes early and enjoy tax-free withdrawals later – potentially an advantageous move by John.
- Case 2: Sarah, an individual non-spouse beneficiary, inherits her uncle’s traditional IRA worth $300,000. Sarah has high income levels and falls within the top tax bracket; as she would like her Uncle’s traditional IRA converted to a Roth IRA for tax-free growth and withdrawals but due to current tax laws it cannot be converted.
Case studies like these emphasize the need for tailored guidance. Each situation differs and the best solution for one person may not be the best for everyone else.
While an inherited IRA can be converted to a Roth IRA for spouse beneficiaries only, doing so involves paying income tax but may offer long-term tax advantages in certain circumstances. Non-spouse beneficiaries do not have this option available to them and therefore cannot convert an inherited IRA to one in this manner.
Navigating the complexity of an inherited IRA and potential conversion requires an in-depth knowledge of both its rules and your personal circumstances and objectives. Given the potentially disastrous ramifications of any mistakes or miscalculations, consulting a financial adviser or tax professional for assistance is recommended.
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