How to Manage an Inherited IRA: What Beneficiaries Need to Know
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 has 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 1/2 to distribute the funds penalty free.
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 only way to combine accounts is if you inherit multiple IRAs from the same account owner and they are all subject to the same distribution rules.
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, 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 five years, then any withdrawals taken before the five-year period would be subject to income tax on any earnings.
Just because you won’t need to pay income taxes on the withdrawals doesn’t mean you should rush to distribute this account right away. The ability to avoid paying taxes on any investment earnings can be valuable and is certainly worth considering.
Take the Year-of-Death RMD
If you inherited a traditional IRA this year and the account owner was older than 72, it’s likely 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 based on the account owner’s life expectancy. Just because the account owner died doesn’t mean they are relieved of their RMD for the year.
If the RMD was not taken during the year, the beneficiary is required to satisfy that distribution. Under a recent law change, the beneficiary now has until their tax filing deadline of the following year (including extensions) to take this distribution. If the distribution is not taken, the IRS will assess a penalty up to 25% of the missed RMD. However, the IRS does provide additional relief if the missed distribution is corrected in a timely manner.
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 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.
- Minor 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’re chronically ill, disabled, or not more than 10 years younger than the account owner, you may elect to stretch the required distributions over your own life expectancy. This can allow for years of tax-deferred growth.
However, for all other individual beneficiaries, the account must generally be distributed within 10 years, following the year of death of the account owner. If the original account owner was subject to RMDs themselves, the beneficiary will need to continue those annual distributions for years one through 9, beginning in the year after death. Plus, the beneficiary must still liquidate the account in year 10. This RMD requirement has recently been waived for the 2021-2023 tax years, but is expected to be enforced for the 2024 tax year.
IRAs are allowed to be passed directly to heirs through beneficiary designations and can avoid being held up in probate. However, if an IRA is left to an estate before it’s directly transferred to you, there are completely different 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 account. 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 holds 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 to help you better understand your options. If you have questions about an inherited IRA, please contact us. Savant’s team of advisors is ready to help.
Retirement Plan and IRA Required Minimum Distributions FAQs | Internal Revenue Service
This is intended for informational purposes only. You should not assume that any discussion or information contained in this document serves as the receipt of, or as a substitute for, personalized investment advice from Savant.
Joseph P. Marmorato
Private Client Group Planner