What are the rules when you inherit an IRA?
Inheriting an IRA (Individual Retirement Account) undoubtedly comes at a very stressful time in life as this only occurs when the original account holder passes away.
Although rules were put in place to allow for the easy transfer of assets, the reality is that the process can be quite confusing, especially for spouses. However, inheriting an IRA is truly a special gift and symbol of trust and love.
If you have inherited an IRA—or you are the owner of an IRA and want to know more about the importance of naming beneficiaries on your IRAs—this article is for you.
***SPECIAL NOTE – The “Secure Act” is going to change much of this blog article (updated October 2019) so STAY TUNED!
These are the beneficiary types for IRAs
- Spouse (permits maximum flexibility)
- Non-Spouse (option for a 5-year pay-out or a life-expectancy pay-out)
- Estate Named Beneficiary (with a 5-year pay-out or a life-expectancy pay-out option)
- Charity
- No Beneficiary Named (IRA could enter probate or go to a spouse or child)
- Multiple beneficiaries named (a portion is distributed to each beneficiary)
Spousal beneficiaries
Surviving spouses have the most flexibility regarding the handling of an inherited IRA.
- You can transfer the funds and open an inherited IRA
- This will allow for continued growth
- Can immediately make withdrawals without penalty
- You can roll-over the inherited IRA into your own IRA (only spouses can do this)
- Best if you are older than 59 ½
- Surviving spouses should leave the IRA in the deceased spouses name as a beneficiary IRA if they’re under this age to avoid potential penalties
- You can convert the inherited pre-tax IRA into a Roth (taxes will apply and only spouses can do this)
- Disclaim the inherited account for certain tax or purposes or personal reasons (the assets will then usually go to the children or grandchildren)
- Take a lump-sum payment (taxes may apply)
Spouses are the only individuals who have the option to roll-over the funds into an IRA titled in their own name. This gives them ultimate discretion on the account, most importantly regarding future distributions. However, your ultimate decision will be influenced by many factors such as:
- Income needs
- Age (of both you and your spouse)
- IRA type
In some cases, you may be able to roll the inherited IRA into a qualified employer plan, a 403(a) or (b), or into a 457(b) plan.
Age & RMDs – If both you and your spouse (at time of death) are not yet 70 ½ years, you can choose to roll-over the inherited IRA into your own IRA and keep the assets in your tax-advantaged account. In this case, you will not be obligated to take the required minimum distributions (RMDs) in the case of a traditional IRA.
If your spouse was over 70 ½ (and therefore was taking RMDs), you will have to see if your spouse took the necessary RMD for the year in which he/she passed away. If not, you will need to make the year-of-death RMD (calculated using the uniform life expectancy table and inserting your spouse’s age at death) under your social security number prior to December 31. If you miss this deadline, you may be subject to an IRS penalty equal to 50% of the RMD.
Look at this IRS table for more clarification on RMDs for beneficiaries.
You can also take RMDs one year after your spouse’s death, or begin taking them at the time that your spouse would have taken RMDs (at age 70 ½). You may not want to take RMDs at this time, however. If this is the case, you can transfer the inherited IRA into your own IRA just before the RMDs would have been required for your spouse.
RMDs will be counted as ordinary income, and taxed accordingly. If the deceased’s IRA was a Roth (and the money was in the Roth for at least 5 years) distributions are tax-free. If you convert any of yours or your spouse’s traditional IRAs into a Roth, you will have to pay taxes upon the Roth conversion.
As you can see, it would be a wise decision to talk with a tax expert upon inheriting an IRA. There are many tripwires which could cost your loved ones a lot of money (and some of your hard-earned legacy!)
Income needs – If you do need income, be careful of how you handle the inherited IRA. You may be subject to the 10% early withdrawal penalty under the following circumstances:
- You inherit a traditional IRA, and
- You roll-over the IRA into your own traditional IRA, and
- You are under age 59 ½ and
- You make a withdrawal
To avoid the 10% early withdrawal penalty, you could roll your IRAs into the inherited IRA or just keep the inherited IRA as a separate account (from which you can take distributions) and take distributions according to the life expectancy table.
Annuitize the IRA – Distributions can be deferred entirely until the required minimum distribution needs to be met or stretched out over the life expectancy of the surviving spouse.
Non-spousal beneficiaries
Non-spousal beneficiaries don’t have the same flexibility as spouses. Inherited IRAs have to remain titled in the name of the deceased with the beneficiary listed (i.e. Jane Doe Beneficiary IRA of John Doe IRA).
Non-spousal heirs have essentially four options:
- Take a lump sum payment (and pay taxes)
- Cash-out the IRA within 5 years (this will be included in your income). You don’t have to withdrawal any specific amount, but you do have to empty it within 5 years.
- Take RMDs based on your life expectancy
- Take RMDs based on the oldest beneficiary’s life expectancy (if multiple beneficiaries were listed)
In either case, the IRA retains its tax-deferred status and money is not taxable until withdrawn from the account.
Inherited Roth IRAs are subject to different distribution rules – Unlike your own Roth, inherited Roth IRAs are subject to RMDs and these must begin by December 31st of the year after death if you are a non-spouse beneficiary.
RMDs will be determined using the single life expectancy table. Roth RMDs are tax-free unless the account had not been funded for at least 5 years. Of course, you can withdraw the principal contributions made by the owner at any time without tax or penalty.
If the December 31st deadline for periodic payments based on life expectancy is missed, the heir will have a tax penalty of 50% of that distribution amount (this goes for both the traditional and Roth IRAs). If the deceased account holder had begun RMDs, the heir of the IRA must take the year of death RMD.
Estate named beneficiaries
If an estate is named as a beneficiary of a Roth IRA, all funds must be withdrawn within five years.
In the case of a traditional IRA,
- the funds must be withdrawn in five years, UNLESS
- the original owner had already begun required minimum distributions. In this case, future distributions for heirs are based on the remaining life expectancy that would have been true for the deceased.
If an estate inherits an IRA, hiring a tax expert would be a very smart choice. Depending on the specifics of the IRA, and whether or not it included nondeductible contributions, will affect the tax burden on the estate.
If you are considering naming your estate as a beneficiary, keep in mind the costs associated with the probate fees. The fees are steep and usually a percentage of the overall estate. Therefore, this can create unnecessary costs.
Charitable beneficiaries
Some people may name a charity as a beneficiary for tax and estate planning purposes. This can reduce the tax burdens on the estate and heirs of the IRA, as well as provide a great benefit for the receiving charity. This can be a more beneficial way to donate to charity as compared to donating during one’s lifetime.
Multiple beneficiaries
If more than one beneficiary is listed on the decedent’s IRA, the account total will be distributed among the named beneficiaries. Distribution percentages are normally determined at the time that the multiple beneficiaries were added to the account.
No named beneficiary
If no beneficiaries are named, the default action is usually
- To pass the IRA to the estate of the deceased and it will pass through probate
- To transfer the IRA to a spouse or children (at the discretion of the custodian’s default policy)
These two scenarios go through different processes and have different tax treatments. If the assets go to probate, other family members could also claim a portion of the assets.
In short, it could get messy and very expensive. This is why it is unanimously agreed upon that not naming a beneficiary is a bad idea. You can protect your assets and loved ones when you fill out a beneficiary form (which should only take a few minutes).
Do you have an inherited IRA?
If you’ve inherited an IRA it’s very important to play by IRS rules! Not doing so can land you in hot water in the form of steep taxes and/or penalties. See a qualified tax professional and if you don’t have one we’d be happy to recommend one for you!