401(k) Financial Planning

You Be The Advisor – Widower and The Roth

How about we flip the tables, and make you the advisor this month? Does that sound fun? Are you up for the challenge? Good!

You are approached by a widower who is younger than 59 1/2. He has inherited a Roth IRA from his spouse. He is gainfully employed, and life insurance proceeds were sufficient to pay off the remaining balance of the mortgage. However, he is concerned about liquidity and having access to money in case he needs it. What do you tell him to do with his deceased spouses Roth IRA?

  • Option one, distribute all proceeds and put the money in the bank.
  • Option two, claim the Roth IRA as his own.
  • Option three, claim the Roth IRA as an inherited (beneficiary) Roth IRA

All three of these options are potential advice that someone might hear from a financial advisor. However, today you are the financial advisor. How would you advise the widower?

Cashing everything in, and receiving a check seems logical. Because the IRA is a Roth there is no immediate tax consequences of this action. The Roth IRA is distributed 100% tax free. That’s sounds like a good idea, right?

However, following this advice means that the Roth IRA dollars are no longer special. As a Roth IRA, the account earns interest tax deferred and all distributions are tax free.

The IRS also limits the amount that one may contribute to a Roth IRA on an annual basis. Depending on the size of the account, it could take a decade for the widower to contribute the same amount of money to his own Roth IRA.

What seems like good advice, and perhaps harmless, could actually harm your client in the long run.

It probably makes more sense to advise your client to elect the IRA as his own. Right?

The account would maintain its Roth IRA characterization. It would then be treated as if the Surviving spouse had contributed to the IRA himself. Any interest or rate of return earned would grow tax deferred.

In fact, because the Roth IRA is treated as his own he could contribute to it up to the maximum annual limit. This must be the better action to take. Don’t you think?

Well..! Not so fast.

When distributions are made after 59 1/2 all distributions would be tax-free. However, what about distributions prior to 59 1/2? What if the widower needs cash sooner than later? This is where things can get a little sticky.

While it may be possible to take contributions made it to a Roth IRA prior to 59 1/2, there would be a penalty on the withdrawal of any tax deferred interest. The 10% excise tax is assessed for early withdraw from a retirement plan prior to 59 ½.  

Advising the surviving spouse to except the deceased spouses Roth IRA as an inherited Roth IRA would likely be a superior action to recommend. It would allow him to keep earning tax deferred interest while maintaining access to the money without penalty. All withdraws before and after 59 1/2 would be tax-free.

The one drawback perhaps is that as an inherited Roth IRA, the widower would no longer be able to make contributions to it. However, he could simply contribute to his own Roth IRA up to the maximum limit per year.

A second potential drawback is that the IRS will require that the beneficiary withdrawal a specified amount from the account on an annual basis. These are known as required minimum distributions, or RMDs.  Very much like required minimum distributions on a traditional IRA after the owner has reached 70 1/2, beneficiaries of IRAs are required to make withdrawals based on the previous years December 31 value divided by the age specific divisor in the IRS table. Albeit required, these distributions would be relatively small. Most likely less than 1/35 of the account value because of the surviving spouse‘s age it will barely be noticeable and beats the other two alternatives.

Leave a Reply

Your email address will not be published. Required fields are marked *