How to Manage an Inherited IRA: What Beneficiaries Need to Know

Post Written by: Joseph P. Marmorato, CPA

The tax code is complicated and the rules surrounding inherited IRAs aren’t any different.

In fact, the rules for inherited IRAs have become quite complex over recent years due to new legislative changes. As a beneficiary who’s inherited someone else’s retirement account, you now have complete ownership over the account. However, that doesn’t mean you can treat it like other IRAs you may already own. When you first inherit an IRA, there are a few key rules you should be aware of to help avoid any unintended consequences.

Inherited IRA Rules

First, you cannot make additional contributions to the inherited IRA. You may, however, hold the funds in the account for a specified period of time, depending on your relationship to the account owner. The assets may also be liquidated immediately, no matter who inherits the account. Better yet, these distributions can be taken penalty free regardless of your age. This is one significant difference when it comes to inherited IRAs from one you already hold as there is no requirement to reach age 59.5 in order to distribute the funds penalty free.

Now, unless you are the spouse, you will need to transfer the funds from the current IRA to a new, inherited IRA account. The funds cannot remain in the deceased owner’s original account. You also can’t roll an inherited IRA into your own retirement account. The inherited IRA must always be a stand-alone account and cannot be combined with other IRAs, even if they are inherited as well.

The Type of Account Matters

It’s important to understand exactly what type of IRA you own, as different types of IRAs have different rules.

There are two main types of IRAs, including traditional IRAs and Roth IRAs. The key difference between the two is that a traditional IRA is allowed to be funded with before-tax dollars and can give you an immediate tax break. A Roth IRA, on the other hand, must be funded with after-tax dollars and is intended to provide a future tax break.

A traditional IRA allows for contributions to be made with either pre-tax or post-tax dollars. If you inherited a traditional IRA, any distributions that you take will likely be subject to income tax. These distributions increase your own taxable income for the year, potentially pushing you into a higher tax bracket. You may choose to have some withholding taken out of the distribution to help cover the potential additional tax liability.

Traditional IRAs also allow for after-tax contributions to be made, which can help reduce the taxable portion of any distributions. This after-tax amount is referred to as basis and if it exists, it should be reported on the original account owner’s final tax return. Beneficiaries get the benefit of claiming any basis that belongs to an IRA, so it’s essential to see if it exists for your inherited IRA.

In contrast, a Roth IRA only allows for after-tax contributions. That means if you inherited a Roth IRA, you do not have to pay any income tax on the distributions that you take. Even if your account earns investment income such as interest and dividends, it can all be taken out income tax-free. There is one precaution with a Roth. If the original owner did not own the account for more than 5 years, then any withdrawals taken before the 5-year period would be subject to income tax on any earnings.

Just because you won’t need to pay income taxes on the funds doesn’t mean you should rush to distribute this account right away. The ability to avoid paying taxes on any investment earnings can be very valuable and is certainly worth considering.

Take the Year-of-Death RMD

If you inherited a traditional IRA and the account owner was age 72 or older, it is likely that they were obliged to take annual distributions from the account, known as required minimum distributions (RMDs). These distributions are enforced by the Internal Revenue Service and are determined by the account owner’s life expectancy. Just because the account owner died doesn’t mean they are relieved of their RMD. If the RMD was not taken during the year, the beneficiary is required to satisfy that distribution. And if the RMD is not taken by December 31st in the year of death, the required amount to be withdrawn would technically be subject to a 50% penalty.

The IRS recently issued proposed regulations to provide some relief to taxpayers who find themselves in this situation. As long as the RMD is taken by the time that the beneficiary files his or her tax return in the following year, the 50% penalty will be automatically waived. If this is discovered after that time frame, relief may be requested through a separate process, so all is not lost. However, these regulations have not been completely finalized yet, but are likely to be later this year.

What Are Your Payout Rules?

You may be subject to different payout requirements depending on your relationship with the original account owner. There are different rules for spouses, minor children, adult children, siblings, and friends. These rules were recently reconstructed when the SECURE Act was signed into law back in 2019. Congress ultimately decided that retirement accounts are meant to be for retirement only and are not meant to be passed on to heirs. As a result, these new beneficiary categories were created to expedite distributions and limit favorable tax treatment. These new beneficiary categories have very specific rules and requirements and generally apply to IRAs that are inherited after January 1, 2020.

  • Spouses: The tax law provides spouses with the most favorable IRA treatment. A spouse may designate themselves as the account owner, roll the account over to their own IRA, or they may even elect to be a beneficiary and take the distributions over their own life expectancy. A spouse can continue to make contributions to the account and is allowed much greater flexibility than other beneficiaries.
  • Children: The options available to children who inherit an IRA largely depend on their age. If a child is age 21 or older, the account most likely is required to be distributed within 10 years of the original account owner’s death. Annual distributions may or may not be required, depending on the circumstances. However, if a child is under age 21, distributions from the account can be stretched over their life expectancy until the child reaches age 21. In such a case, the entire account must then be distributed within 10 years after reaching the age of majority.
  • Other beneficiaries: For friends, siblings or other beneficiaries, the rules tend to be less favorable. If you are less than 10 years younger than the IRA owner, chronically ill or disabled, you may elect to stretch the required distributions over your own life expectancy, allowing for years of tax-deferred growth. However, for all other individual beneficiaries, the account must generally be distributed within 10 years after the year of death of the account owner. Annual RMDs may or may not be required.

IRAs are allowed to be passed directly to heirs through beneficiary designations and can skip getting held up in the estate. However, if an IRA is left to an estate before it’s transferred to you, there are completely separate distribution rules that apply, which are likely to be even less favorable than if you just inherited it outright. It’s crucial to understand what distribution rules apply to you to help avoid any adverse tax consequences.

Other Considerations

There are numerous other considerations to be made when you inherit an IRA. To start, it’s crucial to name your own beneficiary on the IRA. If the financial institution allows it, look to name both a primary and contingent (or secondary) beneficiary. This way you can ensure that the funds pass on to those you wish to receive the account if anything were to happen.

Most financial institutions also allow you to transfer your account to another custodian. However, a transfer of the account must be completed by a trustee-to-trustee transfer. The institution that currently owns the IRA will either wire the funds or issue a check made payable to the new custodian. This way, you will never have access to the funds during this process. While the tax code allows for certain IRAs to be rolled over through a 60-day rollover, this provision does not apply to inherited IRAs. Make sure you speak to your financial institution prior to transferring any funds to make certain that it is properly handled.

Finally, if for any reason you do not wish to inherit the account, you also have the option of disclaiming the inheritance itself. If you disclaim the inheritance and were identified as a primary beneficiary, the inheritance will pass to the secondary beneficiary as though you never were even named to receive the inheritance in the first place. This must usually be completed within nine months of the account owner’s death.

Seek Professional Guidance

The rules surrounding IRAs are quite complex and may require the assistance of a professional advisor. Be sure to consult with a Wealth Advisor to help you better understand your options with your inherited retirement account so that you can plan accordingly. Our advisors at Domani Wealth are always available to start a conversation, and you can get in touch with us by calling 855-855-5455, or emailing info@domaniwealth.com.

 

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