Can You Convert an Inherited IRA to a Roth IRA?

An inherited Individual Retirement Arrangement (IRA) is an account that a beneficiary receives following the death of the original owner. The funds within a traditional inherited IRA are pre-tax, meaning withdrawals are taxed as ordinary income. A Roth conversion is the process of moving these funds into a Roth IRA, where qualified withdrawals can be tax-free, but this action requires paying income tax on the entire converted amount at the time of the transfer.

The rules governing whether a beneficiary can convert an inherited IRA depend almost entirely on the beneficiary’s relationship to the original account owner. For some, a conversion is a straightforward option, while for others, it is prohibited.

Conversion Eligibility and Beneficiary Rules

The ability to convert an inherited traditional IRA to a Roth IRA depends on whether the beneficiary is the surviving spouse of the deceased. A surviving spouse is the only beneficiary who can treat an inherited IRA as their own. This allows them to roll the assets into their own traditional IRA, where the funds are no longer subject to inherited IRA rules. From there, the money can be converted to a Roth IRA following standard procedures.

A non-spouse beneficiary, such as a child or sibling, cannot treat an inherited IRA as their own and is prohibited from converting it to a Roth IRA. An exception exists for assets inherited from a workplace retirement plan, like a 401(k). These funds can be directly rolled over and converted into an inherited Roth IRA.

The current rules for non-spouse beneficiaries divide them into two main categories. “Eligible Designated Beneficiaries” (EDBs) include the owner’s minor children, disabled or chronically ill individuals, and those not more than 10 years younger than the decedent. EDBs can take distributions over their life expectancy.

Most other non-spouse beneficiaries, like adult children, are “Non-Eligible Designated Beneficiaries.” These individuals are subject to a 10-year rule, which mandates that the entire account balance must be withdrawn by the end of the 10th year after the owner’s death.

The specifics of this rule depend on whether the original owner had begun taking Required Minimum Distributions (RMDs). If the owner had started RMDs, the beneficiary must also take annual distributions in years one through nine. If the owner had not yet started RMDs, the beneficiary can wait to withdraw the entire balance at any point before the 10-year deadline.

Information and Decisions Required for Conversion

Before a surviving spouse proceeds with a conversion, they must gather information and make several decisions. The first step is to confirm the beneficiary designation with the financial institution, or custodian, that holds the IRA. This verification ensures the spouse is recognized as the beneficiary.

It is important to determine the value of the assets within the inherited IRA. This valuation is the basis for calculating the income tax that will be due upon conversion. The entire amount moved from the traditional IRA to the Roth IRA will be treated as taxable income in the year the conversion takes place.

A strategic decision involves choosing how much of the IRA to convert. A surviving spouse can convert the entire account at once or execute partial conversions over several years. Spreading the conversion can help manage the tax impact by potentially avoiding a jump into a higher tax bracket.

A key planning point is deciding how to pay the resulting tax liability. The income tax owed on the conversion should be paid with funds from a separate, non-retirement account. Using money from the inherited IRA to cover the tax bill is considered a distribution and could be subject to a 10% early withdrawal penalty if the spouse is under age 59.5.

Finally, the beneficiary must obtain the necessary conversion paperwork from the IRA custodian. These forms will require account numbers for both the traditional IRA and the new Roth IRA, personal information, and the exact dollar amount being converted.

The Step-by-Step Conversion Process

Once a surviving spouse has completed the preparations, the conversion process involves a series of procedural actions. The first step is to submit the completed conversion forms to the financial institution, which can be done online, by mail, or in person.

The transfer of assets from the inherited traditional IRA to the new Roth IRA can occur in two ways. An “in-kind” transfer moves existing investments directly into the new Roth account without selling them. Alternatively, the assets can be liquidated, and the resulting cash is moved to the Roth IRA for reinvestment.

A new Roth IRA must be established in the surviving spouse’s name to receive the converted funds. It is important that this account is titled correctly as the spouse’s own IRA, not as an inherited account. This step solidifies the spouse’s ownership of the assets.

After submitting the request, the financial institution will process the transaction. The beneficiary should expect to receive a confirmation statement showing the funds have been moved from the traditional IRA and deposited into the new Roth IRA.

Tax Reporting and Financial Impact

The total amount converted from the traditional IRA to the Roth IRA is added to the beneficiary’s ordinary income for the year the conversion occurs. This increase in income is taxed at the beneficiary’s marginal tax rate.

The transaction is reported to the beneficiary and the IRS by the financial custodian on Form 1099-R. The beneficiary will receive this form in the year following the conversion. A distribution code in Box 7, such as ‘2’ or ‘7’ depending on the beneficiary’s age, combined with a code ‘G’ for a direct rollover, often signals the conversion.

The beneficiary must use the information from Form 1099-R to complete their personal income tax return. Form 8606 is used to report the conversion, and the taxable amount is then transferred to the appropriate line on Form 1040.

This increase in Adjusted Gross Income (AGI) can have secondary financial consequences. A large conversion could push the taxpayer into a higher federal income tax bracket or reduce eligibility for various tax credits and deductions that are phased out at higher income levels.

Managing the Inherited Roth IRA Post-Conversion

After a conversion is complete, the new account is governed by a specific set of rules. The conversion does not reset the distribution timeline established by the original inheritance. The rules from the original inherited account carry over directly to the new inherited Roth IRA.

For most non-spouse beneficiaries who converted an inherited 401(k), this means the 10-year rule remains in effect. The clock, which started at the end of the year the original owner died, continues to run. The entire balance of the new inherited Roth IRA must be fully distributed by the end of that 10th year. Failing to empty the account by this deadline can result in a substantial penalty on the remaining balance.

The primary benefit of the conversion is that all qualified withdrawals from the new inherited Roth IRA are completely tax-free. This is the trade-off for having paid the income tax on the entire account balance at the time of the conversion.