Come not between the dragon and his Roth

I really wish they hadn’t called it an IRA.

Back in 1997, a senator named William Roth pushed through a law which allowed for a different type of retirement account. Up until then, if you wanted to save for retirement in a way that was tax-advantaged, your only option was a traditional IRA, or one of its close cousins like a 401(k) or SEP. There were minor differences, but these IRA-type accounts pretty much worked the same. There was a tax deduction when you put the money in, but you had to pay tax when you took the money out.

So with the traditional IRA, the government eventually got their bite of your money. The advantage to you was that you would presumably take the deduction when you were working and were in a higher tax bracket, and then you would report the income and pay the tax on it later, when you were retired and your income was not as high. So, you would pay a lower tax rate on that money.

With a Roth IRA, you don’t get a tax deduction when you put the money in. But you also don’t pay tax on it when you pull the money out, as long as you wait at least five years to withdraw from it. “So what,” you might say, “the same thing happens when I put the money in a savings account.” Ah, but here’s the difference: with the savings account, you have to pay tax on the interest. With the Roth, all of the gains (interest, dividends, capital gains, and so forth) are tax-free.

The reason I wish they had not called them “Roth IRAs”, as opposed to something like “Roth accounts” is that people get confused between the two types of retirement accounts, and perhaps try to mix them together, or pull money out of an IRA prematurely thinking it is a Roth. The two types of accounts are completely different, and you have to be clear which one you are dealing with, and what the rules are for that type of account.

The rules are also different when you inherit a regular IRA-type account, and when you inherit a Roth. There are a lot of similarities, particularly for inheriting spouses. With a few exceptions, an inheriting spouse gets the same deal the deceased spouse would have had. For a non-spouse inheriting either type of account, the rules are very different.

When you inherit a Roth from someone other than your husband or wife, you have two options. You can cash it out. In that case you don’t have to pay any tax on it (unless the person who died left more than $5.5 million in total assets, but that’s a different tax). If it is a regular IRA, 401(k) or the like and you cash it out, you have to pay income tax on the whole thing, as if it is ordinary income in the year you cash it out. That can mean a huge tax hit, because it pushes you into a really high tax bracket for that year.

The other option with a Roth is to roll that money into a “beneficiary Roth”. If you do that, you can continue to roll that investment forward, with no tax on the gain when you pull it out. However there is a significant difference between what the person who died could do with that Roth, and what you as his heir can do with the beneficiary Roth. The creator of the Roth never has to take required minimum distributions, regardless of how old he is. As a non-spouse inheriting a Roth and rolling it into a beneficiary Roth, you have to take out a little bit each year as a required minimum distribution.

But the good news is, you don’t pay income tax on those required minimum distributions. You don’t get to keep rolling that small, withdrawn portion of the account forward tax-free, but you can still roll the rest of it forward.

That’s not a bad deal at all. It also means that an estate planner has some options for dealing with the Roth. If the beneficiaries are reasonably responsible adults, I tell my clients to leave the Roth directly to them as beneficiaries on the account, even if I am telling the same clients to leave other accounts to a living trust. But if the beneficiary is a minor, or is not particularly responsible, they also have the option of leaving the Roth account to the trust, in which case there is no tax to be paid. There is an opportunity lost, but no tax at that time.

Final point: the laws related to Roths, like a lot of other tax laws, are extraordinarily complex. Don’t take any action based solely on this article, which has necessarily left out a lot of details. Talk to your tax accountant or financial advisor first.

(The title of this article is from King Lear).

Kenneth Kirk is an Anchorage estate planning lawyer. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account. I really mean it this time!

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