Transferring wealth of any kind creates both opportunities and risks for the giver and receiver’s financial plans. Inherited IRAs can be especially confusing to those on the receiving end because the tax laws require that you treat someone else’s retirement savings different from your own. How do you incorporate the inherited IRA assets into your existing financial plan? What options are available for distributions? What does this mean for taxes? Following are some answers to frequently asked questions by beneficiaries.
What is an Inherited IRA?
When an individual opens an IRA, he or she will name a beneficiary to receive any assets remaining in the account after the individual’s death. A beneficiary may be a spouse, child, charity, trust, or another individual. Inherited IRAs are designed specifically for beneficiaries who are taking payments of inherited IRA assets. There are a few factors that influence the guidelines and distribution options for Inherited IRAs, including the beneficiary’s relationship to the original account holder, the age of both the original account holder and the beneficiary, and the account type (traditional or Roth).
What are the general rules for Inherited IRAs?
When you inherit retirement savings, the federal tax laws require that you distribute the entire account within a certain amount of time. Beneficiaries who inherit retirement savings on or after January 1, 2020, will generally have 10 years following the year of the account holder’s death to deplete the entire account. Certain types of beneficiaries, called Eligible Designated Beneficiaries, have additional options, including taking a minimum distribution each year over their life expectancy. An Eligible Designated Beneficiary (EDB) is a
- Surviving spouse
- Disabled individual
- Chronically ill individual
- Child of the account owner (only until the child reaches the age of majority)
- Non-spouse beneficiary who is not more than 10 years younger than the account holder
How does age affect an Inherited IRA?
Age can influence the distribution options for certain beneficiaries. For example, whether the original account holder was older or younger than the age to begin taking required minimum distributions (RMDs) can affect the payment options available to an Eligible Designated Beneficiary. Another important age milestone is 59½. This age is important for a surviving spouse beneficiary who rolls over the account balance into his or her own traditional or Roth IRA. If the spouse withdraws any of the funds from their own IRA before reaching age 59½, a 10% early distribution tax typically applies. A child who inherits IRA assets from a parent will have the additional distribution options available to them, but only until they reach the age of majority in their state. When they reach that age, they must deplete the inherited IRA within 10 years. If a non-spouse beneficiary is less than 10 years younger than the account holder, that beneficiary will have more distribution options than another younger beneficiary.
What are my options if I inherit an IRA from a spouse?
As mentioned above, the account holder's relationship to the beneficiary is an important factor in how the beneficiary may treat the Inherited IRA. Spouses are one of the most common types of beneficiaries. Spouse beneficiaries have more options than non-spouse beneficiaries:
Designate self as the account holder
If you designated yourself as the account holder of the inherited assets, the traditional or Roth IRA becomes your own IRA. Beneficiary distributions are no longer required, and RMDs are determined based on your age. You can make contributions to the IRA if you are eligible.
Roll over the inherited IRA assets
Rolling over the inherited IRA assets into your existing traditional IRA or into a qualified employer plan such as a 401(k) is another way to claim the inherited assets as your own retirement savings.
Transfer assets to an Inherited IRA established in your name as beneficiary
Transferring the assets of the original IRA into an Inherited IRA that you establish will maintain the beneficiary status of the assets. You can take distributions over your own or the original account holder’s life expectancy or over a five-year period. The specific options available depend on the original account holder’s age at death. You cannot make contributions to an Inherited IRA.
Take a lump sum distribution
All beneficiaries may take a complete distribution of the inherited assets at any time. Because distributions from a traditional IRA are generally taxable, a lump sum distribution of the entire IRA may cause a significant increase in your tax liability. Distributions from a Roth IRA are generally tax free. If fewer than five years have passed since the account holder opened a Roth IRA, only the investment earnings distributed are taxable. You will not incur the 10% early distribution tax even if you are under age 59½.
What are my options if I inherit an IRA from someone other than a spouse?
If you inherit IRA assets from an individual other than a spouse, you have fewer options.
Transfer assets to an Inherited IRA established in your name as beneficiary
If you were not married to the account holder at the time of their death, you cannot treat inherited IRA assets as your own. This means you cannot make any new contributions to the IRA or roll over any amounts into or out of the inherited IRA. However, the IRS does allow you to move the IRA assets to another custodian through a transfer to an Inherited IRA you establish to receive the assets.
Whether you inherit a traditional or a Roth IRA, you are required to deplete the account within a certain time frame. If you are an Eligible Designated Beneficiary, life expectancy payments must begin no later than December 31 of the year following the year of the account holder’s death, or the account must be depleted within a five-year period. The specific options available depend on the account holder’s age at death. If you do not fall into any of the categories to be an Eligible Designated Beneficiary, you must distribute the entire IRA within 10 years following the year of death. You can take any amount of payment (including zero) in any year, so long as the account is emptied within 10 years.
Take a lump sum distribution
You may always take a full distribution of the inherited assets at any time. Because distributions from a traditional IRA are generally taxable, a lump sum distribution of the entire IRA may cause a significant increase in your tax liability. Distributions from a Roth IRA are generally tax free. If fewer than five years have passed since the account holder opened a Roth IRA, only the investment earnings distributed are taxable. You will not incur the 10% early withdrawal penalty even if you are under age 59½.
What if I don’t distribute the IRA assets in time?
If you do not take payment of inherited IRA assets when you are supposed to based on the tax laws, you will owe an excise tax equal to 50% of the amount that should have been withdrawn but was not.
How do I get started?
There are many benefits to inheriting IRA assets, including being allowed to leave the IRA assets invested to continue growing tax-deferred for as long as the rules permit. Spreading out distributions from the IRA over multiple years can also reduce the tax impact of the inheritance.
- Talk to a financial advisor. They can help you understand your payment options, as well as guide you on investing the IRA assets based on your distribution timeline.
- Contact the IRA custodian to find out if they have any special documentation or timing requirements. Most IRA custodians require a copy of the death certificate before they will move inherited IRA assets.
More questions? Contact Mainstar Trust or call 800-521-9897.