inherited IRA
inherited IRA

Rules to know if you’ve inherited an IRA

Saving for retirement is a top priority when it comes to financial planning. We all hope to reach financial freedom and enjoy our golden years, live comfortably, travel, and spend time with loved ones. Looking past our own needs, many of us also have family members we wish to provide for long after we are gone. 

There are trillions of dollars in Individual Retirement Accounts (IRAs), and it is not uncommon to have portions of retirement savings pass to a beneficiary. An inherited IRA is an individual retirement account that is transferred to another individual after the original owner’s death. Inherited IRAs come with their own set of rules based on the type, beneficiary relationship, and age of the account.  

Rules for non-spouse inherited IRAs

A non-spouse beneficiary could be a grandchild, sibling, cousin, aunt, uncle, or really anyone the original owner designates other than his or her spouse. In the year of the original owner’s passing, the beneficiary will follow the RMD schedule that the original owner was subject to follow. After that year, non-spouse beneficiaries of an inherited IRA must move the money into a beneficiary IRA account. If there are multiple beneficiaries, each individual must set up their own beneficiary IRA account. 

Inherited IRAs are subject to required minimum distributions, or RMDs, regardless of the age of the beneficiary. Prior to 2020, individuals that inherited an IRA were able to stretch RMDs over their own lifetimes, allowing that IRA balance to continue to potentially grow (commonly known as a stretch IRA). However, the SECURE Act of 2019 changed this for most non-spouse beneficiaries, who now must withdraw the entire remaining IRA value within ten years (with a few exceptions). While the total amount must be withdrawn in those ten years there are no annual RMDs for each of those years. The beneficiary may take it all out at once, or as they see fit, depending on their financial situation and tax strategy. If the inherited IRA account balance is not zero by the end of the tenth year, the beneficiary will be subject to a 50% penalty tax on the remaining IRA value. The 10-year rule begins the year after the original owner passes away. 

The exceptions to the 10-year rule are for the following beneficiaries:

  • Minor children
    • The 10-year rule begins when the child reaches the “age of majority” in his or her state of residence, which is typically 18 years old.
  • Beneficiaries within ten years of age of the original IRA owner
    • In these cases, the RMDs are based upon the life expectancy of the beneficiary.
  • Disabled or chronically ill beneficiaries
    • Withdrawals from the inherited IRA can be based on the life expectancy of the beneficiary if they meet the IRS’s definition of disabled or chronically ill.

Rules for IRAs inherited by the deceased’s spouse

Individuals who have inherited an IRA from a spouse will receive different treatment. Spouses who have inherited an IRA will generally use the IRS’s RMD calculations table (based upon life expectancy) to determine their annual RMD. However, there can be exceptions based upon the age of the deceased and the age of the beneficiary. 

It is important to note that if the IRA owner did not take an RMD in the year of his or her death, the spouse is still responsible for fulfilling that requirement. After year one, there are a few options for taking on an inherited IRA as a spouse that may have tax benefits.

  • Remain the beneficiary of the IRA
    • If a spouse remains the beneficiary of the IRA the RMD will be calculated based on the age of the original owner.
  • Roll over the money into an existing IRA
    • If an inheriting spouse decides to roll over the money into an existing IRA the RMDs will then be based on the age of the new owner. 
  • Become the owner of the existing IRA
    • If an inherited spouse chooses to become the owner of the IRA, RMDs will be based on the life expectancy of the new owner and will not begin until the owner is 72 years old. This can be advantageous if the surviving spouse is younger than 72 and doesn’t wish to tap the account balance. If the surviving spouse is younger than age 59 ½ and chooses to take early withdrawals, the withdrawals will be taxed as ordinary income but avoid the 10% early penalty fee. 

The five-year rule for inherited IRAs

The IRS’s 5-year inherited IRA rule applies to the following two situations:

  • No beneficiary
    • If the original owner of the IRA did not set up any beneficiaries, the estate will need to withdraw all funds from the account within five years of the passing of the original owner. 
  • A Roth IRA that’s under five years old
    • Inherited Roth IRAs are not subject to RMDs, however they do have their own special rules. If a Roth IRA account is fewer than five years old and has been inherited by a beneficiary, the withdrawals will be taxed as ordinary income. To avoid this taxation, the beneficiary must wait until the account reaches the five-year mark before withdrawing funds tax-free. 

Tax planning with inherited IRAs

Beneficiaries of Roth IRAs will generally not see any change in their tax rate since withdrawals from Roth IRAs are tax-free. However, individuals who have inherited a traditional IRA could potentially be bumped to a higher tax bracket due to the 10-year rule. For a non-spouse beneficiary, this could have a major impact on your income taxes. It’s important to have a conversation with your CPA to discuss how inheriting an IRA could affect your taxes and what could be done to reduce your taxable income for the years in which you have to take distributions.  A tax professional can look at your overall financial picture and help you come up with a plan that is most favorable to you.

If you have recently inherited an IRA, it is important to consult with your financial advisor or CPA. Proactive planning could mean more money in your pocket at the end of the day, and less handed over to the Treasury.

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