When a loved one passes, there are a lot of steps to take when closing out their estate. Inherited IRAs are one of the trickier tasks.
The process is complex because it involves three major components: financial, estate, and tax planning.
If you’re the beneficiary of an individual retirement account, read on to learn how to handle the process confidently and avoid some of the most costly mistakes beneficiaries make.
What is an inherited IRA?
Inherited IRAs help transfer a deceased owner’s retirement account to one or multiple named beneficiaries. These accounts, also called “beneficiary IRAs,” can be funded with inherited assets from the following several types of retirement accounts.
How do inherited IRAs work?
Inherited IRAs can be established from all types of IRAs—whether a traditional, a SEP, a SIMPLE, or a Roth IRA—it qualifies. They can also receive funds from certain employer-sponsored plans like 401(k)s and 403(b)s.
This is because the income tax treatment of the individual retirement account remains the same when it passes from the original account owner to the beneficiary.
Whether the account has pre-tax dollars from a traditional IRA, SEP IRA, or SIMPLE IRA or was funded with after-tax dollars in a Roth IRA, the rules still carry over to an inherited IRA.
When the IRA owner passes, those distribution rules carry over to their beneficiaries. However, the rules depend on various factors, such as age and marital status. This is where it gets more complicated.
Here’s a breakdown of the rules for the different factors.
Inherited IRA options for spouses
If you are the only beneficiary of your spouse’s IRA, you can take control of the account through a spousal transfer or “assume” the IRA.
The IRS will regard the account as if it was yours from the beginning. That means you are allowed to keep adding to the inherited IRA, and the timeframe for taking required minimum distributions is adjusted based on your life expectancy (instead of the decedent's).
Since you’re the sole beneficiary, you can transfer the funds into your name in a few ways:
- Assume ownership by naming yourself as the owner of the account.
- Roll the funds over from the original owner’s account into an IRA in your name. (Tip: make sure the tax treatment is the same for the inherited IRA assets as the account you’re rolling into, whether traditional or Roth IRA.)
- Set up a new account in your name to roll the inherited account assets into (if you don’t have an IRA already).
- Receive the assets in a lump sum as cash. (Tip: consult a tax professional before taking any distributions; you may encounter a significant tax liability if you choose this option.)
Inherited IRA options for non-spouse beneficiaries
You will have a little more work to do if you are a “non-spouse” inheriting an IRA, whether solely or with multiple people, or a spouse who is not the sole beneficiary.
- Unlike spouses, non-spouses cannot roll an inherited IRA into one of their existing accounts. The IRS inherited IRA rules will make you move your share of the funds into a brand new inherited IRA. The account will be titled in the name of the original IRA owner (the deceased owner) for the benefit of (FBO) you.
- Future contributions are also prohibited - even though you are the account owner, you can’t add to it.
- Depending on when the account holder passed away, you may need to take required minimum distributions (see below for more information).
What are required minimum distributions (RMDs)?
The IRS mandates that IRA and defined contributions plan owners withdraw a certain percentage from their accounts annually once they reach age 73. The Secure 2.0 Act increased this limit by one year in 2023. These mandatory withdrawals are called Required Minimum Distributions.
What’s the point of Required Minimum Distributions?
Without required minimum distributions, people who don’t need to tap into their retirement accounts could defer taxes for their whole lives and then pass that preferential tax treatment onto their heirs. RMDs ensure this doesn’t happen.
How do Required Minimum Distributions work for inherited IRAs?
If the owner passed after December 31, 2019, the majority of IRA beneficiaries must exhaust the assets within ten years of the account owner’s death.
You can withdraw money from the account anytime and as frequently as you want, but you must ensure the account is empty by the end of the ten years.
Note: Every distribution from a traditional IRA is considered income to the IRS, so expect to pay taxes in the year of the transaction.
10-year rule exemptions to know
The following situations are exceptions to the rule:
- If you are the spouse of the deceased account owner, you can treat it as your own and take distributions over your life expectancy.
- If you are a minor child, you don’t have to empty the IRA by the 10-year deadline; instead, it must be depleted within ten years after you reach the “age of majority,” which is 18 in most states.
- If you are disabled, chronically ill, or not more than ten years younger than the deceased account owner, you can take distributions over your life expectancy.
If you received IRA assets from someone who passed away prior to December 31, 2019, you are exempt from the 10-year rule. You can take the withdrawals over your lifetime duration.
How does the 5-year rule work for inherited IRAs?
The contributions made to a Roth IRA can be withdrawn by beneficiaries without tax implications at any point in time. However, it’s important to note that this rule only applies to Roth IRA contributions.
If you inherit a Roth IRA, you can also take any profits out tax-free. The only stipulation is that the account must be at least five years old as of the date of the account holder’s death.
What happens if the Roth IRA was less than five years old when the original account holder died?
In this case, the five-year rule states that earnings withdrawn are taxable.
It is important to understand that although the original owner of a Roth IRA is not required to take RMDs during their lifetime, beneficiaries must take one to avoid penalties.
How much? Up to 50% of the account value.
Final word
If you are a beneficiary of an IRA, properly following the rules that meet your specific situation can be challenging.
No matter which type of inherited IRA you have, consulting a financial professional can help you make the right decision the first time.
