Being named as the beneficiary of an individual retirement account (IRA) is a testament to the deep love and trust someone had for you. It’s a profound honor, and it comes with a responsibility to understand the complexities of an inherited IRA.
Unlike a standard IRA, inherited IRAs are intricate products with rules that can vary based on your relationship with the original account owner. Here’s a closer look at the nuances of an inherited IRA.
What Is an Inherited IRA?
An inherited IRA is an account you may have to open when you’re named as a beneficiary of an employer-sponsored retirement plan or IRA and the original owner passes. You might inherit the IRA from a spouse, parent, grandparent, sibling, loved one, an entity, or a completely unrelated party.
As the beneficiary, you can enjoy the preferential tax treatment of an IRA, but inherited IRAs involve complex rules about timelines and distributions. These rules center around your relationship with the original account owner. For instance, spousal beneficiaries have the most flexibility in managing the inherited IRA, while non-spousal beneficiaries must generally draw the account down within 10 years.
How Inherited IRAs Work
Also referred to as a “beneficiary IRA,” an inherited IRA can be opened with the proceeds from any type of IRA, such as a:
- Roth IRA
- Traditional IRA
- Rollover IRA
- Savings Incentive Match Plan for Employees (SIMPLE) IRA
- Simplified Employee Pension (SEP) IRA
Unlike spouses who can assume ownership of their late partner’s IRA, non-spouses must move funds from the original account holder’s IRA to a new inherited IRA. This transfer is critical and must occur promptly—even if you plan to receive a lump-sum distribution.
The purpose of the inherited IRA is to have a specially identified account that involves strict withdrawal rules. For tax purposes, you must report beneficiary IRAs and any distributions via forms 1099-R and 5498.
Distribution Options for Beneficiary IRAs
How you can receive the IRA distribution depends on whether you’re a spousal or non-spousal beneficiary. In either case, you can elect to receive a lump-sum distribution or disclaim the inheritance.
Spousal beneficiaries have more options for receiving the benefits than non-spousal beneficiaries. Non-natural beneficiaries, like a trust, estate, charity, or business, have the least.
Spousal Beneficiary Options for Managing an Inherited IRA
As a surviving spouse, you can take any of the following actions.
Take a Lump-Sum Distribution
Lump-sum distributions offer instant access to funds and are simple, one-time transactions. However, the entire amount is subject to income tax in the year of distribution, which could increase your tax burden.
Open an Inherited IRA and Take RMDs
This option allows you to spread out the taxable income over several years. However, it can be complex if you want to maximize your legacy because you have to take annual required minimum distributions (RMDs).
Keep the IRA as Your Own
You can treat the IRA as if you’re the original owner, or you can roll it into your existing IRA. If you choose either of these options, the standard RMD rules apply, which means you may need to start taking distributions by April 1 of the year after you turn 73.
As long as the distribution isn’t an RMD, you have 60 days from receiving the distribution to roll it into your IRA.
Remain a Beneficiary on the IRA
You could also decide to remain a beneficiary. In doing so, the IRA would stay in the original account holder’s name and you’d delay taking RMDs until the original owner would’ve turned 73. If you’re younger than the original account holder, retaining your beneficiary status can allow you to delay distributions longer.
Non-Spousal Beneficiary Options for Managing Beneficiary IRAs
Like a spousal beneficiary, you can take a lump-sum distribution or disclaim the inheritance as a non-spousal beneficiary. But that’s where similarities end. A non-spousal inherited IRA has different rules, whether you’re a child, sibling, relative, or friend.
These are the regulations you must adhere to:
- You can’t treat the inherited IRA as your own, so you can’t make additional contributions.
- You can’t transfer inherited funds into an existing IRA account.
- You can’t leave the assets in the original IRA.
- You must establish a new inherited IRA account.
10-Year Withdrawal Rule
As a non-spousal beneficiary, you must empty the account within 10 years or you could face a 50% fine on the balance. Additionally, poorly managing the distributions could lead to more taxes.
Distributions and RMDs for Inherited IRAs
RMDs are the minimum amount you must withdraw from your account each year, and understanding how they work is crucial when inheriting an IRA. The process of handling RMDs depends on whether you’re a spouse or a non-spouse beneficiary.
Spousal beneficiaries often have more flexibility in how and when to take distributions, while non-spousal beneficiaries must adhere to stricter timelines. In addition to understanding your relationship to the original account holder, you must also be aware of the holder’s age when they passed away.
RMDs for Spousal Beneficiaries
If the original owner started receiving RMDs before they passed, you have two options as the spousal beneficiary. You can continue to receive the RMDs as calculated or submit a new RMD schedule based on your life expectancy.
Alternatively, you can roll the account into your own IRA. In this case, the standard IRA rules would apply, and RMDs would start once you turn 73.
RMDs for Non-Spousal Beneficiaries
Before the SECURE 2.0 Act, non-spousal beneficiaries could handle RMDs like spousal beneficiaries. So, you could recalculate RMDs based on your life expectancy, which reduced the yearly withdrawal amount and the taxes due on traditional IRAs.
Today, the SECURE Act mandates that you empty the account within 10 years of the original owner’s death on accounts inherited after December 31, 2019.
Exceptions to the 10-Year Rule
As with most situations, the 10-year withdrawal rule has exceptions. You’re exempt if:
- You’re chronically ill or disabled.
- Your age is within 10 years of the deceased account holder.
- You’re a minor child who is the immediate descendant of the original account holder. When you reach the age of majority, the 10-year rule applies.
If you’re exempt, the pre-SECURE 2.0 Act distribution rules and schedules apply. You can withdraw in increments or all at once without a hard withdrawal timetable.
Time Constraints for Beneficiary IRAs
You must access the funds in an inherited IRA by a certain time based on your relationship with the original account holder.
Spousal Beneficiaries
As a spouse, you have more flexibility when it comes to timing. You can delay RMDs until you reach age 73, giving you control over when to begin accessing the funds.
Non-Spousal Beneficiaries
Under the 10-year rule, you must withdraw the entire IRA balance by the end of the 10th year following the original owner’s death. You don’t have any annual distribution requirements, but you must empty the account within the 10-year timeframe.
Beneficiary IRA Penalties
Beneficiary IRAs can involve penalties in certain cases.
As a spousal beneficiary, you can be subject to a 10% early withdrawal penalty if you treat the inherited IRA as your own and withdraw funds before age 59½. However, if you leave the IRA as an inherited account, the early withdrawal penalty typically doesn’t apply, even if you’re under 59½.
As a non-spousal beneficiary, you have no early withdrawal penalties for accessing funds from an inherited IRA, regardless of age. However, you must empty the IRA within 10 years or you could face a penalty on the remaining balance.
How Inherited IRAs Are Taxed
Inherited IRA distributions are subject to income taxes, but the rules differ slightly depending on the type of IRA.
Traditional IRAs
Distributions from an inherited traditional IRA are taxed as ordinary income for both spousal and non-spousal beneficiaries. So, any amount you withdraw is added to your annual taxable income, potentially pushing you into a higher tax bracket.
Roth IRAs
Distributions from an inherited Roth IRA generally aren’t taxed if the account has been open for at least five years. Even so, you must withdraw the entire balance within 10 years if you’re a non-spousal beneficiary, which can impact your tax planning.
Contact Bankers Life for Help
Navigating the rules and options for an inherited IRA can be complex, but making informed decisions can help maximize the benefits. It’s wise to start planning before the original account owner dies. Converting a traditional IRA to a Roth IRA may help maximize your legacy because distributions from the latter aren’t taxed.
Fortunately, Banker’s Life can help you every step of the way. Contact a seasoned Bankers Life representative for assistance with understanding your options.
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