It’s never easy to lose someone. And along with the personal loss often comes the need to address financial matters when a loved one passes away. Some common financial items that often need to be addressed when someone passes include executing their will, other aspects of their estate plan and inheritance. For listed beneficiaries, inheriting certain assets such as Individual Retirement Accounts (IRA) can be a unique challenge due to complex rules and potential tax implications.
If you are a beneficiary for an inherited IRA, your first instinct may be to simply collect the funds within the IRA by taking a lump sum distribution. But that may cause you to increase your taxable income, and ultimately sacrifice potential tax-deferred growth.
Depending on who the IRA belonged to (spouse or non-spouse), and if you’re inheriting a traditional or Roth IRA, different inheritance rules may apply. It’s always a good idea to discuss inherited IRAs with a fiduciary financial advisor, as every situation is unique.
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In this article, we’ll discuss several key rules you should be aware of if you inherit an IRA (Traditional or Roth) as a beneficiary.
1. If You Are a Spouse and Beneficiary
For sole beneficiaries who are also the spouse of the deceased individual, you can assume ownership of the IRA by a spousal transfer. You can treat the IRA as if it was your own retirement account by naming yourself as the owner of the IRA.
As the beneficiary, you can also rollover the deceased’s IRA into a qualified employer plan, qualified annuity plan, tax-sheltered annuity plan, or deferred compensation plan of a state or local government such as a 457(b). An advantage of rolling over the deceased’s IRA into your own qualified retirement plan is the ability to defer Required Minimum Distributions (RMDs) of the funds in a Traditional IRA until you reach the age of 72. If you do roll over the funds into a qualified plan or your own IRA and take a distribution before the age of 59½, then you will likely be subject to a 10% early withdrawal penalty.
According to the IRS, it’s also important to note that if a surviving spouse receives a distribution from their deceased spouse’s IRA, that distribution can be rolled over into an IRA of the surviving spouse within a 60-day time limit, as long as the distribution is not a required distribution. This applies even if the surviving spouse is not the sole beneficiary of his or her deceased spouse’s IRA.
A Note on Inherited IRAs and RMDs
Required Minimum Distributions are important to keep track of for inherited Traditional IRAs in order to avoid potentially hefty penalties. If the original owner of the IRA had already started receiving RMDs at the time of death, the beneficiary must continue to receive the distributions as calculated or submit a new schedule based on their own life expectancy which could provide the account more time to grow tax-deferred, or tax-free if it is a Roth account that has been held for at least five years.
For spouses who inherit the Traditional IRA and take distributions they will need to pay taxes on their withdrawals.
Tip: As the inheriting spouse, you should determine if you need to access the funds prior to reaching the age of 59½. If you do need to access the funds, it likely makes sense to receive the assets in an Inherited IRA, which avoids the 10% early withdrawal rule, but would be subject to a 10 year distribution rule for Inherited IRA’s. If you won’t need to access the funds or you’ve already reached age 59½, it could be more beneficial to claim the assets as your own so you avoid the 10 year distribution requirement.
2. If You Are a Non-Spouse Beneficiary
Due to the recently implemented SECURE ACT, non-spouse beneficiaries must adjust to new guidelines when it comes to inheriting. Non-spouse beneficiaries can take a lump sum distribution, but as noted earlier, that will lead to potentially more taxable income. Unlike spousal beneficiaries, non-spouses must establish an Inherited IRA as the IRS does not allow you to rollover the money from the deceased IRA into your own retirement account or contribute funds to the deceased’s IRA.
For IRAs inherited after Dec 31st, 2019, the SECURE ACT mandates that non-spouse beneficiaries will need to distribute the Inherited IRA within 10 years of the original owner’s death. Those who are disabled, chronically ill, or within 10 years of age of the deceased individual may be exempt from this withdrawal guideline. In addition, minor children who are direct descendants of the deceased can be exempt from the rule until they are deemed age of majority by their state of residency.
It is important to understand that there are no annual requirements on your distributions, as long as the entire amount of funds is distributed within 10 years. If you fail to complete this 10-year requirement, you may be subject to a 50% penalty.
Tip: Depending on if you inherit a Traditional or Roth IRA, it may make sense to adjust the timeline of how you distribute the funds within the 10-year requirement. For a traditional IRA, it could be beneficial to take distributions each year to avoid having to take out a large lump sum in one particular year. If you take a large sum at once, this may push your taxable income into a higher tax bracket. On the other hand, if you inherit a Roth IRA, it may make sense to leave the funds within the Inherited IRA for as long as you can. By leaving the funds in the Inherited IRA, the account will continue to grow tax-free as you will not have to pay taxes when the funds are distributed from a Roth IRA.
3. If You Are Not A Designated Beneficiary
Inheriting an IRA does not always come by way of listed beneficiaries, as IRAs can also be passed down through an established estate. The distribution method used for inheritors through estates will likely follow the old rules from before the SECURE Act. The below list of actions are likely to be used to distribute the assets in the IRA:
- Disclaim the inherited retirement account and pass it along to a different person
- Take a lump sum distribution
- Distribute the assets within five years (there is no annual RMD requirement) if the original account owner died before their RMD age
If you are a beneficiary and inherit an IRA, it’s important that you get a complete understanding of your options, and the potential outcomes of each available option for you and the inherited IRA. I’d encourage you to consider working with a fiduciary financial advisor and/or an estate professional to assess the best course of action. Consulting a professional will help you avoid any nasty surprises in the form of penalties or taxes.
Here are a few more steps you can take to help ensure your finances are in order when you inherit an IRA:
- Sign Up for Personal Capital’s free financial tools, which include the Retirement Planner – a sophisticated retirement calculator that will allow you to see how your inherited IRA will impact your retirement readiness. You’ll also be able to track your net worth, analyze your portfolio, and spot any hidden fees.
- If you haven’t already, find a fiduciary financial advisor who can help guide you through the rules around your inherited IRA.