Does inherited IRA impact Roth conversion?

Financial Planning Tax Strategies
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I’ve been regularly doing a ‘backdoor Roth’ conversion as my income is around or sometimes above the Roth conversion threshold.

My father passed away in April and left me, in part, a decent sized though not enormous traditional IRA. That, plus the other funds I moved/planned to move around has realized some capital gains which means I’ll likely be above the threshold (“unfortunately”, some of those funds came from an irrevocable trust, and as such didn’t get the step up in basis, so they have gains).

Anyway, I’m wondering, I know for tax/basis purposes, all IRAs you own are treated as one. So if you have another traditional IRA with no basis, that will impact the taxable portion of the Roth conversion.

My question is, does this include the Inherited IRA and it will prevent me from doing the ‘backdoor Roth’ maneuver?

Looking at the form 8606 instructions, I’m thinking no - the Inherited IRA is accounted for separately? I’m thinking this because the line 2 instructions for form 8606, don’t mention inherited IRAs and simply point you back to last year Form 8606 for the basis, not saying to count any value from anything inherited. And line 6 instructions say to include “Enter the total value of all your traditional, traditional SEP,
and traditional SIMPLE IRAs” (emphasis mine).

And then if I look up the information about inherited IRAs in Pub 590-B, it says:
If you inherit a traditional IRA from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. Unless you are the decedent’s spouse and choose to treat the IRA as your own, you can’t combine this basis with any basis you have in your own traditional IRA(s) or any basis in traditional IRA(s) you inherited from other decedents. If you take distributions from both an inherited IRA and your IRA, and each has basis, you must complete separate Forms 8606 to determine the taxable and nontaxable portions of those distributions.

So this seems to say, athough not addressing this exact situation, that the Inherited IRA is treated separately on it’s own Form 8606, and therefore doesn’t impact my ability to do my own nondeductible IRA->Roth conversion.

Did I piece that together correctly?

And if so… what’s the chance that my tax software will do it that way… lol.

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2

Sorry for your loss.

You are the beneficiary of an inherited IRA, not the owner.

From IRS Pub 590-A Publication 590-A (2023), Contributions to Individual Retirement Arrangements (IRAs) | Internal Revenue Service (irs.gov)

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Since you are not the owner, the inherited IRA is not counted as a part of your total IRA balance for Form 8606.

You should confirm that titling of the account is something like “Inherited IRA FBO DeltaOne81” (where FBO means For Benefit Of), or “DeltaOne81, Beneficiary of DeltaOne81’s father’s IRA”. You should see the word ‘beneficiary’ or ‘inherited’ somewhere in the account title. If you don’t see one of those words in the title, you need to get with the brokerage and be sure that they show that it’s an inherited IRA.

I will point out that if your father turned 73 on or before the day he died, not only are you required to fully distribute the IRA within 10 years, you must take RMDs from the IRA each year. And for 2024, you need to be sure that at least the minimum RMD for 2024 was distributed to you, him and/or a combination of both of you. IRS Pub 590-B Publication 590-B (2023), Distributions from Individual Retirement Arrangements (IRAs) | Internal Revenue Service (irs.gov) has information on calculating RMDs for an inherited IRA.

AJ

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Hasn’t the IRS kicked that can down the road for now?

Additionally, with the recent SCOTUS ruling on Chevron, one wonders if the IRS may not lack the rule-making authority to require a RMD.

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Assuming the decedent was of an age that RMDs were required, 2024 is the year of death, so an RMD is required for 2024 anyway. And since, according to the notice, 2024 is likely the last year of relief, beginning next year, RMDs would be required.

I guess we will see what happens with that. Until then, the rules still state beginning in 2025, RMDs will be required.

AJ

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Thanks for the responses. Glad I got that right and that my backdoor Roth contributions aren’t impacted.

He was not quite 73, so I don’t think I have an RMD, but I do likely plan to spread the distribution roughly evenly over the 10 years anyway.

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As long as he hadn’t turned 73 as of the day he died, then you have no RMD requirement.

I suggested to my brothers that they distribute 1/10 of the account balance the first year, 1/9 the 2nd year, 1/8 the third year, etc. until they distribute the entire remaining balance in the 10th year.

There are potentially ups and downs due to changes in the account value, but this strategy is more likely to result in roughly equal inflation-adjusted distributions than setting a specific dollar amount.

AJ

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IRS has an update!

‘Insanely Complicated’

The final rules, however, make “retirement accounts (even more) insanely complicated to deal with on a practical level,” Henry-Moreland added in the LinkedIn post.

As to No. 1 question advisors have asked for two-plus years now: “Are ANNUAL distributions required DURING the 10-Year Rule?” Yes, Levine said, “IF death occurred on or after the RBD.” Also, as a “Reminder: Thanks to Notices 2022-53, 2023-54, and 2024-35, this rule won’t actually begin to apply until next year (2025).”

Note, I still could not find any details as to HOW to determine the RMD, just that one must happen?!?

Link to the 260 pages. Good luck finding it :slight_smile:
https://www.federalregister.gov/documents/2024/07/19/2024-14542/required-minimum-distributions

Hopefully, your brokerage will help when the time comes - but they spent the last 4 years telling people to talk to their tax professional so :man_shrugging:

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Did you look in IRS Pub 590-B p590b.pdf (irs.gov)? These are the rules for eligible designated beneficiaries:

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AJ

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I am familiar with that table, are you saying that the 10 year required distribution schedule will be using the old lifetime RMD table?

If so, that will certainly result in a ridiculous amount of people that get hammered in the last year because they did not take out much more than the RMD.

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I’m not sure why it wouldn’t be.

They’ll be hit less than those who inherit T-IRAs subject to the 10 year rule and don’t distribute even RMDs because the original owner hadn’t reached their RMD age, so RMDs weren’t required.

When inheriting a T-IRA that is subject to the 10 year rule, you really need to look at whether the tax deferral aspect on any additional gains is worth taking the tax hit on the full distribution in the 10th year. If you have specific circumstances, like you control all of your other income so that the inherited IRA will replace some/all of your other income in the year you distribute it, or it’s a small enough IRA that it wouldn’t impact you significantly from a tax perspective, then leaving the money in a T-IRA subject to the 10 year rule until the final year may be a reasonable choice. But for most people who inherit a T-IRA that is subject to the 10 year rule a good rule to follow is (as I suggested above)

This distribution scheme will probably result in a better result from a tax perspective, and if RMDs are required, will exceed RMD requirements unless the beneficiary is older than 81 when they inherit the IRA.

Edited to add:

And this is why I don’t understand why advisors are bringing up the whole discussion on RMDs for inherited T-IRAs being so complex. If the advisor is doing a good job for their client, in most cases, they should be suggesting to their client to distribute more than the RMD requirement annually, since the client has to empty the entire account in 10 years anyway.

Yes, there are specific circumstances where specific clients may have enough control over the income they can realize to make waiting more tax-efficient. But most people don’t have that much control over their income, even in retirement, much less if they are still working when they inherit.

AJ

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And as I was going to close the tab for the article that you linked to, I noticed another article cited at the bottom of the page:

How to Calculate RMDs for Inherited IRAs | ThinkAdvisor which says:

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So, yes, Table I is the appropriate table.

AJ

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This is why you are one of my favorite posters here @aj485, cut through the obfuscation and get to the meat of the matter. Since it all has to be distributed in 10 years anyway, the RMDs (which are based on a table that is often longer than 10 years) aren’t particularly bothersome. That is unless there is a different timing of income. And it goes both ways, I could see some people wanting to take more in 2024/25 and less in 26-33 if they think their marginal tax rate will be lower in 2024/25 and higher beginning in 2026.

I do have one additional question. What if the beneficiary dies before the 10 years have elapsed? Does the inherited IRA go to their beneficiaries with a new 10 year clock starting at that point, or does the original 10 year clock continue with the new beneficiaries? And I imagine it’s a huge mess in the interim if it takes longer than the current year to settle the estate.

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Yep, that’s definitely another consideration, if you can take out money without pushing yourself into a higher bracket than you anticipate being in beginning in 2026 - if the law isn’t changed.

The successor beneficiary has 10 years after the original beneficiary’s death to fully distribute the IRA. So, a new 10 year clock starts. The RMD clock is still determined by the original owner’s age as of their death.

As long as the original beneficiary sets up successor beneficiaries, the IRA will pass outside of probate, and doesn’t need to wait for the estate to be settled.

AJ

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Because two reasons:

  1. Not everyone works with a professional and those that don’t, are very likely to only take the minimum. This is the group of greatest concern.
  2. Not even those that do work with someone will always follow advice.

As someone that spends an inordinate amount of time every year trying to get people to take their RMD from their own IRA (I have about 40 accounts that are not set up for systematic RMD - at the client’s request), I see it as an issue that will likely result in excess taxes and penalties.

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I don’t see how any of that relates to complexity of RMDs from inherited T-IRAs, since people who fall into those categories aren’t going be seeing those articles, and advisors aren’t going to be able to get them to pay attention anyway. Maybe they’re trying to get the attention of Congress, so Congress will change the law?

The rules for taking RMDs from T-IRAs after the SECURE Acts aren’t that different from the rules for taking RMDs before the SECURE Acts. It’s actually simpler for those who inherit from a decedent who hadn’t reached RMD age, since they don’t have to take RMDs, while they were required to do so before. And the rules for those who inherit from a decedent who had reached RMD age are the same as they were before the SECURE Acts.

And the fact that to pay the least amount in total taxes, most beneficiaries should be taking more than the RMD amount out each year anyway kind of makes the RMD rules moot.

And I see it as an attempt to get some beneficiaries to take something out of their accounts to minimize the taxes and penalties that will result in the 10th year if they don’t require RMDs.

I don’t see why a beneficiary who should be taking RMDs now but chooses not to would have taken RMDs if they had inherited the account before the SECURE Acts. So, no additional taxes or penalties there.

And there are some beneficiaries who would have chosen not to take RMDs under either set of rules who won’t be hit with penalties now because their decedent hadn’t reached RMD age. So that’s actually less in penalties.

The additional taxes that you seem to have an issue with are those associated with having to fully distribute the account within 10 years, rather than over the beneficiary’s lifetime - which has nothing to do with the complexity of the rules.

And that’s something that advisors have been complaining about ever since the SECURE Acts were being proposed. So it looks to me like they are just trying to find a different way to complain about the parts of the SECURE Acts they don’t like. For instance, I haven’t seen any articles complaining about the increases in RMD ages, even though that’s likely to increase taxes for people who wait to begin distributions until they reach RMD age.

AJ

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It isn’t about seeing the article, it is about them (and their broker) being told to take out X% on a regular schedule that doesn’t result in the last year being a massive tax hit.

Much like you suggested, something like 1/10, 1/9, 1/8 would be a MUCH BETTER and logical schedule that would likely result a lower tax burden for beneficiaries.

No doubt I absolutely preferred the old method of being able to stretch it but in the absence of such, beneficiaries need a better schedule than the current one.

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Which penalties are you referring to here exactly? If someone inherits a T-IRA and no RMD is required (because the original owner died before RMDs were required), and they decide to take it all in year 10 and none of it in the first 9 years, which penalties would be assessed?

I could think of a plausible scenario where this could make sense, for example, a person who is working and plans on taking an unpaid sabbatical 9 years after inheriting the IRA. Since they will have no wage income that year, they could take the entire distribution and much of it will be taxed at the lower bracket rates.

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Two things:

  1. There is no “penalty” for waiting until the final year. There is simply the risk of having more income realized in just one year versus 10 years.

  2. There is a penalty if they fail to take it all by year 10. Unless I am mistaken, that excise tax is 25% of the RMD amount (or 10% if corrected in a timely manner).

I have clients (retired teachers) who have a single bene for their seven figure IRA accounts. The possibility exists that the bene will end up having to pay a higher tax rate on her RMDs than the parents saved in their 403bs due to this shortened schedule - and if the daughter messes up and doesn’t take all of it by year 10 (maybe she forgets the year and only takes the age-adjusted RMD in year 10 like she did for all prior years), she could face over $100,000 in excise taxes.

I will be long retired by the time the daughter is faced with that issue but it worries me none the less.

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I suppose no grandchildren yet … if there were grandchildren, it would make a lot of sense splitting it up among them instead!

Have you run the numbers to see if it might be possible that it would be worth doing some conversion to Roth each year until one of them dies? This despite probably having two pensions plus social security coming in. They still might have some headroom in the 22/24 percent brackets.

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Yes, we are doing that every year - but let’s keep in mind that not all investors will be working with someone to help them navigate all these changes (I have yet to encounter a single new client that had any awareness of the changes) so this macro issue is larger than just those in my book of business.

This is an issue that is going to utterly hammer some unsuspecting benes - and it is both unfortunate and unnecessary.

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