Your Quick Guide To Inherited IRAs

The death of a loved one can be a very emotionally trying time, yet many account beneficiaries end up having to make decisions with significant implications on their personal finances. Understanding how inherited IRAs work is critical if you are the beneficiary of one or are working on estate planning involving your individual retirement accounts. The rules for inherited IRAs have changed in the last several years, making tax and financial planning imperative for avoiding penalties.

What Is An Inherited IRA?

An inherited IRA or beneficiary IRA is a type of retirement savings account inherited when the original owner of an IRA or employer-sponsored retirement plan passes away. The beneficiary becomes the account holder of the IRA and could be a spouse, family member, friend, estate, trust, etc.

The withdrawal rules for IRA assets and tax implications for inherited IRAs vary depending on several factors, including:

• Whether the designated beneficiary is a spouse, disabled or chronically ill or the minor child of the account owner
• If the account owner died before or after January 1, 2020, when new rules took effect
• The type of retirement account (i.e., 401(k), Roth IRA, SEP IRA, etc.)

How An Inherited IRA Works

If the original account owner’s death occurred on January 1, 2020, or later, and you are a non-spouse beneficiary, you must open an inherited IRA account. Then you, as the inheritor, have 10 years to fully distribute the funds. However, there are some exceptions for specific IRA beneficiaries, such as minor children of the account owner.

You don’t need to create an inherited IRA account if your spouse is the original account owner. Instead, you can put the money into an IRA in your own name or roll it into an existing IRA. Although the 10-year distribution rule doesn’t apply here, you’ll need to continue taking the required minimum distributions (RMDs) if the original account was in RMD status. 

The type of IRA impacts the tax implications of inherited IRAs and includes Roth IRAs, SEP IRAs, SIMPLE IRAs and traditional IRAs. How you distribute your inherited IRA funds can have major short- and long-term financial and tax implications. Speaking with a financial advisor or CPA could help you create a plan for distributing the funds.

What To Know About Inherited IRA Rules

Numerous laws impact the IRS inheritance process and the financial implications. Non-spousal beneficiaries have fewer options for inherited IRAs than surviving spouses.

Year Of Death Distributions

IRA accounts are subject to RMDs using the life expectancy factor produced by the IRS. If the original retirement account was in RMD status during the year of death, then RMD rules apply. Thus, non-spousal beneficiaries need to continue taking RMDs, but surviving spouses have more options for dispersing account funds.

Income Taxes On Inherited IRAs

Income tax liabilities with the IRS for inherited IRAs vary depending on the type of retirement account. For example, distributions on inherited Roth IRAs are typically tax-free withdrawals. However, if the account was a traditional IRA, the distributions are taxed as regular income at your current tax bracket. Creating a tax strategy to time the distributions may be helpful instead of taking a lump-sum distribution in such cases.

Although most inherited Roth IRAs are not subject to taxes, non-spouse beneficiaries must withdraw all the funds over a 10-year period or incur a 50% penalty. However, if you have inherited an IRA from a spouse and take distributions before age 59 1/2, there is also a 10% withdrawal penalty.

The Importance Of Beneficiary Forms

You must first put the inherited IRA account in your own name to take IRA distributions. Then, request a distribution from the IRA provider by completing the required forms. Remember to report IRA distributions to the IRS when you file your federal income taxes.

Options For Claiming The Inheritance

Your distribution options vary depending on your relationship to the IRA owner, the type of IRA, your tax liability with the IRS and your financial goals.

For Spouses

If you are a surviving spouse of the deceased and the sole beneficiary of the retirement savings account, you have three main options:

1. Roll your inherited IRA account into your own existing or new IRA account: The RMD rules still apply and may be a good option if you want the assets in a tax-advantaged account for as long as possible. Also, if the inherited assets were in a traditional IRA, you can convert them to a Roth IRA.
2. Transfer the IRA assets into an inherited IRA: You won’t be subject to a 10% penalty for withdrawing funds before the age of 59 1/2, but you will need to start taking RMDs when your deceased spouse would have turned 73.
3. Decline to inherit all or part of the IRA assets: The account assets will pass to the remaining primary beneficiaries (if you are not the sole beneficiary) or to the contingent beneficiaries named by your spouse, such as a child, grandchild, trust or charity.

For Non-Spouse Beneficiaries

The SECURE Act of 2019 has major implications for non-spouse beneficiaries because it enacted the 10-year rule for withdrawing funds, with some exceptions. That means that the eligible designated beneficiary must withdraw all the funds from the IRA by the end of the calendar year, 10 years after the account owner passed away. This rule can have a major impact on your income taxes and financial planning.

However, if a minor child of the original account owner is the inheritor, the required beginning date is pushed back. The 10-year rule takes effect when the youth reaches the age of majority (18), and in some cases, can be extended up to age 26. There are also exceptions for disabled and chronically ill individuals.

Inherited IRA FAQs

Here are the answers to some of the most common questions about beneficiary IRAs.

How do I avoid paying taxes on an inherited IRA?

Funds withdrawn from an inherited Roth IRA are typically tax-free when they are qualified distributions, but be sure to follow the 5-year rule to avoid penalties. The 5-year rule applies to accounts whose holder died before 2020, and states that an inherited account must be empty within 5 years of death if the beneficiary doesn’t take distributions from the account or roll it over into their own IRA. If the account holder died after 2020, the 5-year rule does not apply. Note that distributions for traditional IRAs are subject to income taxes. When possible, avoid making withdrawals from traditional IRAs that will put you into a higher tax bracket. A financial advisor can help guide you in minimizing your tax liability from IRA account distributions.

What happens if I inherit an IRA?

Your options depend on if you are the spouse of the deceased account owner. If so, you can roll the funds into your existing IRA or open an inherited IRA (with a 10-year distribution requirement). If you aren’t the spouse, then you must set up a designed inherited IRA account and distribute the funds within 10 years, unless you are the minor child of the decedent account owner or disabled.

Do beneficiaries pay taxes on inherited IRAs?

Typically, beneficiaries will not pay taxes if it is a Roth IRA, but beneficiaries of traditional IRAs do need to pay taxes based on their tax bracket. However, if the beneficiary has 10 years to withdraw all the funds and doesn’t, then a 50% penalty is assessed.

What is the new 10-year rule for an inherited IRA?

The SECURE Act requires that most non-spousal IRA beneficiaries withdraw all the account funds within 10 years or face a 50% penalty. However, this 10-year rule doesn’t apply to spousal IRA beneficiaries that elect to put the inherited assets into their own IRA.

The Bottom Line: IRA Beneficiaries Have Many Options

Inherited IRAs can help boost financial freedom, but it is critical to understand how to avoid penalties and high tax liabilities. Your options will vary greatly depending on your relationship with the deceased and the RMD status of the account. Speaking with a financial planner can be helpful in creating a strategy for dispersing IRA account funds.

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