IRAs and employer sponsored retirement plans are a significant asset for many people. Inherited IRAs represent the most efficient way to pass these assets on to your heirs. It’s important to understand how they work for both IRA account holders and their heirs.
What Is an Inherited IRA?
An inherited IRA also known as beneficiary IRA is an IRA that is opened to house the assets of an IRA account or an employer-sponsored retirement account like a 401(k) that is inherited from the account owner. IRAs and retirement accounts like a 401(k) are passed on via beneficiary designation. A spouse, a child, other family members and relatives, friends or anyone else can be the beneficiary of an IRA or other retirement account.
In the case of a spousal beneficiary, they generally have the option of taking the proceeds of the IRA or retirement account and rolling some or all of this money into their own IRA.
How does an Inherited IRA work?
Both traditional and Roth IRAs or retirement accounts such as a 401(k) can become inherited IRAs.
There are special rules for spousal beneficiaries that are discussed below. For all other types of beneficiaries, money inherited from an IRA or retirement account must either be taken as a distribution or rolled into an inherited IRA account. The inherited IRA must be a separate account segregated from any other IRA account(s) the beneficiary might have. The assets from the inherited IRA cannot be commingled with other IRA assets, with the exception of a surviving spouse as discussed below. Additionally, non-spousal beneficiaries may not make additional contributions to an inherited IRA.
The rules for taking distributions, including required minimum distributions (RMDs), for some non-spousal beneficiaries changed drastically with the SECURE Act that went into effect on January 1, 2020. See the section below for a detailed discussion regarding the SECURE Act.
A key point to remember for all beneficiaries is that if the deceased account owner was required to take an RMD in the year of their death but had not done so or had not taken the full amount, this distribution must still be taken by the end of that calendar year.
Aside from rolling the inherited IRA funds into an inherited IRA account, beneficiaries have the option to take the full amount as a withdrawal, however it is wise to review the potential tax implications of doing this. While there is no 10% penalty on the withdrawal regardless of the beneficiary’s age, the amount withdrawn will be taxed as ordinary income at the beneficiary’s marginal tax rate. If the amount is substantial, this could push you into a higher tax bracket for the year.
How are inherited IRAs taxed?
Inherited IRAs are taxed based on the tax rules for the type of IRA account. Withdrawals from an inherited traditional IRA will be taxed when withdrawn. Withdrawals from an inherited Roth IRA are tax-free if the original account owner had satisfied the five-year requirement prior to their death. This rule requires that the initial Roth contribution was made at least five years prior to the death of the original account owner.
Inherited IRA rules for spouses
As a surviving spouse if you are the sole beneficiary of your late spouse’s IRA you can take over the IRA as if it were your own. This is known as a spousal transfer.
The surviving spouse designates themselves as the owner of the account. They can roll the assets of the deceased spouse’s IRA into their own IRA account as long as it is the same type of account. For example a traditional IRA account would need to be rolled into a traditional IRA, with a Roth IRA rolled into a Roth IRA account. A new account can be set up for this purpose as well.
The surviving spouse beneficiary will then treat the account as if it were their own for the purposes of RMDs if applicable as well as other issues normally associated with an IRA.
How the SECURE Act affected Inherited IRAs
The Setting Every Community Up for Retirement Enhancement (SECURE) Act went into effect on January 1, 2020. The SECURE act contains a wide ranging set of new rules impacting a number of areas surrounding retirement. Perhaps the biggest impact was on inherited IRAs.
For IRAs inherited prior to January 1, 2020, the beneficiary of the inherited IRA could stretch the IRA by taking RMDs based on their own life expectancy. In cases where the beneficiary was considerably younger than the original account holder, this created a situation with relatively small RMDs allowing the inherited IRA account to grow for a number of years.
The SECURE Act created a class of beneficiaries known as eligible designated beneficiaries. This group includes:
- The surviving spouse of the original account owner.
- A minor child of the original account owner, this does not include a grandchild.
- A beneficiary other than a spouse who is less than 10 years younger than the original account owner.
- Beneficiaries who are disabled or chronically ill as defined by the IRS.
All other non-spousal beneficiaries are referred to as non-eligible beneficiaries.
Eligible designated beneficiaries can continue to stretch the inherited IRA as their own as with IRAs inherited prior to January 1, 2020. This means they can take RMDs from their account based on their own life expectancy if they are younger than the original account owner. Exceptions to this are spousal beneficiaries as discussed above. The other exception is a minor child. Once they reach the age of majority for their state, they are covered by the 10-year rule.
The 10-year rule is a very significant change to inherited IRAs that arose from the SECURE Act. This rule requires that all other types of beneficiaries withdraw the entire amount of their inherited IRA within 10 years of inheriting this money.
This change from the prior ability to stretch an inherited IRA can have a big impact on the inherited IRA beneficiary of a traditional IRA in terms of their taxes. The 10-year rule can result in a much larger portion of the inherited IRA going to taxes than the account owner might have planned on. The advent of this rule via the SECURE Act can throw a monkey wrench in the account owner’s plans for their IRA after their death.
The 10-year rule also applies to inherited Roth IRAs. However, where the original account owner had met the five-year rule requirement prior to their death, withdrawals from the inherited Roth IRA are tax-free.
There is no requirement as to when withdrawals from inherited IRAs covered by the 10-year rule must occur. There is no requirement for annual withdrawals, the only requirement is that the entire amount of the inherited IRA be withdrawn by the end of the 10-year period from the date you inherit the IRA.
Advantages of an inherited IRA
The main advantage of an inherited IRA account is that it is a way to efficiently pass assets in an IRA or other retirement to your desired heirs.
What happens if you don't withdraw all funds from an Inherited IRA?
Under the rules for IRAs inherited prior to January 1, 2020, if some or all of the RMD amount is not taken in a given year then the beneficiary account holder will incur a penalty of 50% of the required amount that was not taken.
With the newness of the 10-year rule under the SECURE Act, it’s a bit unclear as to what the penalties would be for failing to withdraw the entire amount of an inherited IRA that is subject to the 10-year rule. The first instance of a violation of the 10-year rule would occur at the end of the 2029 tax year as that is the end of the first 10-year period since the commencement of the inherited IRA rules under the SECURE Act.
Conceivably inherited IRA account holders would be penalized on the amount of the withdrawal not taken. It’s certainly likely these rules including any penalties will be clarified over time.
What is the 10-year rule for inherited IRA?
As discussed above, the 10-year rule pertains to IRAs inherited on or after January 1, 2020 with the commencement of inherited IRA rules under the SECURE Act. These rules state that non-spousal beneficiaries who are not classified as designated eligible beneficiaries must withdraw 100% of the assets in an inherited IRA account by the end of the 10-year period commencing from the date they inherit the IRA.
What is the five-year rule for inherited IRAs?
The five-year pertains to Roth IRAs, regular Roth IRAs and inherited IRAs. It is a key factor in determining whether or not withdrawals from a Roth IRA are tax-free.
One of the requirements for the original owner of a Roth IRA to be able to withdraw money tax-free from the account is that their first contribution to a Roth IRA must have been made at least five years ago.
In the case of an inherited Roth IRA, if the original account holder had satisfied the five-year prior to their death, then the beneficiary will be able to take tax-free withdrawals from the inherited Roth IRA. If the five-year rule had not been met by the original account owner before their death, then the withdrawals from the inherited Roth IRA will not be tax-free for the beneficiary.
Can an inherited IRA be rolled over?
An inherited IRA can be rolled over into the beneficiary’s own IRA only if the sole beneficiary of the IRA is the surviving spouse of the original account owner. The surviving spouse can treat the inherited IRA funds as if the IRA was their own.
Non-spousal IRA beneficiaries cannot roll an inherited IRA over to another IRA account. The inherited IRA money cannot be commingled with any other IRA accounts the beneficiary may own.
An inherited IRA can be a good way to pass assets in an IRA or retirement account to your desired beneficiaries. It’s important to understand the rules surrounding inherited IRAs, especially after the implementation of the SECURE Act. This is important for both the IRA account owner and their beneficiaries.