You can only convert an inherited IRA into a Roth IRA if you inherited the IRA from your deceased spouse. Otherwise, you will not be allowed to convert the IRA directly. You may be able to cash out the IRA, paying income taxes on the amount and a 10 percent penalty, and then contribute to a Roth IRA, but only if the IRA is small, because the maximum annual contribution to a Roth IRA is $5,000.
Taxation of Traditional IRAs
Traditional IRA contributions are generally tax deductible, provided the owner meets the income limits defined by law. The growth is tax deferred, and withdrawals are taxable as ordinary income. You must begin taking distributions by April 15 of the year after you reach age 70 1/2. If you make withdrawals prior to age 59 1/2, you must pay an additional 10 percent penalty, except in certain hardship cases, or if you take the distribution in the form of substantially equal periodic payments over your own life expectancy or the joint life expectancy of yourself and your beneficiary.
Converting to a Roth
Many people are attracted to the Roth IRA because they grow free of federal income tax. As long as the funds remain in the Roth account for at least five years, no tax is due on the withdrawal. Additionally, there is no required minimum withdrawal provision, so assets in Roth IRAs can compound tax free indefinitely, as long as the owner lives.
Converting Inherited IRAs
If you inherit a traditional IRA from your spouse, the law allows you to treat that IRA as your own. You can put your own name on it, and use your own life expectancy to calculate RMDs. Since the IRA is your own, you can also convert it to a Roth by paying the income taxes on the entire amount. However, this option does not exist for non-spousal beneficiaries, because only spouses can elect to treat an inherited IRA as their own.
If you inherited the IRA from your spouse, you may wish to convert to a Roth if you believe that your income tax rates will be higher in future years than they are now. You may also want to convert if you don't need the money and would rather let it grow tax-free indefinitely, or if you believe your estate will be subject to the estate tax. By paying the income tax early, you move the amount you paid in taxes out of your estate. If you are a nonspouse beneficiary and you want to benefit from tax-free growth, you may be able to take a distribution and put the proceeds in a permanent life insurance policy. The cash value in permanent life insurance policies receives tax treatment similar to Roth IRAs, provided the police is not a modified endowment contract, which can occur if the owner tries to pay too much premium into the policy relative to the death benefit.
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