Rules for Inherited IRAs
Inherited IRAs have unique tax treatment as compared to other IRAs. There are even further differences for heirs who were married to the deceased versus those who were not. The most important thing for non-spousal beneficiaries to remember is they have 10 years to empty the account balance after the original account owner’s death.
We recently wrote a post about IRAs that I hope many of you found useful.
As with most of the posts we write, subtopics pop up in research or in explaining a topic. One such subtopic that arose in the IRA post was inherited IRAs (also known as a beneficiary IRA).
Inherited IRAs come with rules that make them very different than standard IRAs. This is especially true for non-spouse beneficiaries.
What is an Inherited IRA?
You’ll be shocked to learn that an inherited IRA is an IRA that one inherits.
Earth…shattering…stuff. That’s why you’re here, right?
What you may not know is that you can’t really treat an inherited IRA like you can your own IRA, unless, in some cases, you are the widowed spouse of the deceased.
Up until the SECURE Act changed things quite a bit, an inherited IRA was actually a pretty awesome way for people to receive an inheritance. Especially young people.
The reason is the beneficiary could stretch distributions from the IRA over the course of their lifetime instead of in just a decade like you get now.
So, if little Johnny (age 7) had a grandpa that bequeathed his IRA or some part of it to his grandson, Johnny would get to calculate his RMDs based on his own life expectancy rather than that of grandpa.
Life expectancy for a 7-year-old is pretty long, so Johnny wouldn’t have had to remove much from the account and would be able to let it grow for decades.
Alas, that was then. What was once known as the Stretch IRA has gone the way of the dodo through progressive tax legislation.
Let’s talk about other rules to bear in mind if you are selecting beneficiaries for your IRA or you have inherited one yourself.
Rules for Spousal Beneficiaries
If your spouse dies and you are the designated beneficiary on the account, you basically get to treat the IRA as if it is your own.
You can rename the owner to make it your own, make withdrawals (partially or in full), or roll it over into your own IRA. If you decide to roll it over, you’ll have 60 days after the death of the original account owner to do this, so don’t drag your feet.
If your deceased spouse had already begun receiving RMDs, you’ll have to keep on taking those out based on their RMD schedule or submit a revised schedule to the IRS based on your own life expectancy.
Rules for Non-spousal Beneficiaries
If you are a non-spouse beneficiary of an IRA, your options are significantly more limited.
To begin, you cannot make contributions to the IRA and you cannot roll it over into your own IRA.
Ultimately, the IRS requires inherited IRA beneficiaries to completely empty the account within 10 years of the original account owner’s death.
We hit on Stretch IRAs a bit above. Those allowed savvy planners to shield IRA assets from taxes for a very long time. The IRS has put an end to this, thus ensuring Uncle Sam will get his due during the IRA owner’s lifetime or shortly thereafter.
Non-spousal recipients do not have to empty the account right away. They are allowed to take out funds in any portion in a given year, as long as the account is emptied by the end of year 10.
The good news about this flexibility is it allows beneficiaries to plan those withdrawals in as efficient a manner as possible. Thus, in low-income years, they can make larger withdrawals to take advantage of lower-income tax brackets and in higher years they can take less.
The one caveat to all of this is whether or not the original IRA owner had begun taking RMDs before their death. If they had already begun, then the beneficiary will have to continue taking those RMDs based on the schedule of the deceased.
Exceptions
As with most things, there are exceptions to the rule.
If the IRA beneficiary’s age is within 10 years of the deceased, they are the minor child of the deceased, or the beneficiary is disabled or chronically ill, then the 10-year rule does not apply.
However, if the beneficiary is the minor child of the deceased, the 10-year rule will kick in for them when they reach the age of majority.
Inherited Roth IRAs vs Inherited Tax-Deferred IRAs
You may be wondering if Inherited Roth IRAs are an exception to the 10-year rule too.
No. They are not.
I’m not saying it makes a lot of sense, but if you inherited a Roth IRA you have 10 years to empty the account too. You just won’t owe income tax on the distributions.
An inherited IRA is not like other inheritance
Some of you may be thinking to yourselves that inheritance isn’t supposed to be taxed unless the estate value exceeds lifetime exclusion.
And you’re mostly right. IRAs are an exception, however.
Inherited IRAs are taxed, even if the balance is $1 and it was literally the only asset the deceased owned.
The primary reason is the money has never been taxed. All other assets of the deceased, (homes, cars, cash, businesses, etc.) haven’t enjoyed the same tax-free lifespan of an IRA.
Sure, you get a free step up in basis when you inherit these other assets, but they were all purchased with income that had already been taxed or the assets themselves were taxed throughout the lifespan of their owner.
It’s like they say, “death and taxes”.
Other Tidbits…
You can find IRS information and forms for inherited IRAs here.
I have heard some unfortunate stories about IRA custodians misleading heirs into believing that they must keep the inherited IRA under the management of the same custodian. This isn’t true.
Instead of opening an Inherited IRA account, you do have the option to take a lump sum payment from the deceased’s IRA. You may want to consider this if the account balance is relatively low and you don’t want to bother keeping up with the distributions over the next decade or if you want the cash now and don’t mind losing a lot of it in taxes to get access to it.
Finally, the rules for inherited IRAs are the same whether they come from an employer-sponsored retirement plan, a SEP IRA, SIMPLE IRA, Roth IRA, or Traditional IRA.
