When an IRA owner does a Roth conversion, there is typically a 5-year clock for the earnings on the converted dollars to be tax free. If a person already had a Roth IRA for 5 years AND is over 59 ½, there is no conversion clock to worry about. For these people, Roth IRA distributions will be both tax- and penalty-free.
But we are not concerned about such “qualified status” situations for this article. Here, we are considering non-qualified IRA owners who must abide by the standard 5-year conversion clock – those under 59 ½ and/or who have not held any Roth IRA for 5 years – and the impact on a non-spouse beneficiary.
What if a non-qualified person did a Roth conversion into their first-ever Roth IRA, but then died two years later? Is there any impact on the non-spouse beneficiary of that converted Roth IRA? Yes! A non-spouse beneficiary must abide by the deceased individual’s holding period on that specific inherited IRA. Even if the non-spouse beneficiary had their own IRA for over 5 years, that will not impact the 5-year clock on the inherited IRA.
Fortunately, Roth IRAs have strict ordering rules that are taxpayer friendly. Contributions come out first, then conversions, then earnings. These ordering rules also apply to inherited Roth IRAs. So, if a non-spouse beneficiary inherits a converted Roth IRA in Year 2, any converted dollars (or subsequent contributions made to the account by the original owner before his death) are immediately available to the beneficiary, tax- and penalty-free. A beneficiary would have to burn through all contributions and conversions within the inherited Roth IRA before being able to reach the earnings. If the non-spouse beneficiary is patient – at least for 3 years in this scenario – then even the earnings will eventually be tax-free.
John, age 50, converts his entire $100,000 traditional IRA to a Roth IRA in 2024. John is under age 59 ½, so he must wait 5 years for the earnings on this conversion to be tax-free. Since the conversion was done in 2024, John’s start date is January 1, 2024, and the end of his 5-year conversion clock is January 1, 2029.
Later in 2024 and again in 2025, John makes an $8,000 contribution to this same Roth IRA ($7,000, plus age-50-and-over catch-up). There is also an additional $20,000 of earnings in the account since his original conversion. That brings the total value of his account to $136,000.
Sadly, John dies in late 2025. His beneficiary is his friend Maggie. Maggie establishes an inherited Roth IRA with the assets in 2026. Maggie has her own Roth IRA that she originally opened 10 years ago. However, that Roth IRA has no impact on this inherited account. Also, it does not matter how old Maggie is. Since John was non-qualified, and since his Roth IRA was only open for two years before his death, Maggie must abide by John’s original 5-year conversion clock. Based on Roth IRA distribution ordering rules, Maggie currently has immediate access to the $16,000 of contributions and $100,000 of converted dollars, tax- and penalty-free. If she takes a distribution from the account, these dollars will come out first. However, she must wait until January 1, 2029 before the $20,000+ of earnings will be tax free.
In Part 2 (to be published Monday, July 29), we will discuss the carry-over impacts of the 5-year Roth conversion clock on spouse beneficiaries.
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