Individual Retirement Accounts (IRAs) are one of the most popular ways to save for retirement, and most workers are familiar with the general rules surrounding their use. However, when an IRA is passed down through inheritance, the rules change. While inheriting an IRA can be a boon, it’s crucial to understand the rules governing it to avoid unnecessary taxes or penalties.
Understanding IRAs: the basics
Before diving into the intricacies of inherited IRAs, it’s helpful to understand the foundational principles governing them.
Traditional vs. Roth IRAs
With a traditional IRA, contributions are tax-deductible, which means you don’t pay taxes on the money you put in, only on what you take out. When you make withdrawals in retirement, they are taxed as ordinary income.
With a Roth IRA, contributions are made with after-tax dollars, so withdrawals are generally tax-free in retirement.
Required minimum distributions (RMDs)
Required minimum distributions (RMDs) refer to the minimum amount that account holders are obligated to withdraw from their IRA annually once they reach a certain age. For traditional IRAs, this obligation begins at age 72 (73 if you reach age 72 after Dec. 31, 2022).
Roth IRAs do not impose RMDs during the lifespan of the account holder.
Inherited IRAs: distinct rules for different beneficiaries
In the context of inheritance, the relationship between the original owner and the beneficiary dictates the operational rules of the IRA. It also matters whether the original owner died before or after they started taking RMDs.
The simplest scenario is when a surviving spouse inherits an IRA after their partner’s passing. In such a case, the surviving spouse has the unique option to treat the IRA as their own, which means they can make contributions or delay distributions until they would normally be required to take RMDs. This is the only scenario where a beneficiary can treat the inherited IRA the same as a personal IRA.
General rules for non-spousal beneficiaries
When you inherit an IRA, and you’re not the spouse of the original owner, you need to keep the following general rules in mind:
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No contributions. You cannot contribute to an inherited IRA the way you would a personal IRA. You can take money out, but you can’t put anything in.
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No commingling. You cannot merge funds from your personal IRA with an inherited one and vice versa.
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Ten-year rule. The ten-year rule requires most non-spousal beneficiaries to liquidate the entire balance of an inherited IRA within a span of ten years.
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Continuation of RMDs. If the original owner had already started taking RMDs, the beneficiary must continue taking the RMDs after the owner’s death, regardless of the beneficiary’s age. In addition to the RMDs, the beneficiary is still obligated to liquidate the account within ten years.
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Absence of RMDs. If the original owner had not started taking RMDs, the beneficiary is not required to withdraw a set amount each year, but they are still bound by the ten-year rule.
Eligible designated beneficiaries
Although relatively rare, there is another distribution option for a select group of individuals the IRS refers to as “eligible designated beneficiaries” or EDBs.
EDBs can include heirs who are:
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Less than ten years younger than the deceased,
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Chronically ill,
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Disabled, or
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Minor children of the original account owner.
These beneficiaries have the option to stretch RMDs over their life expectancy or the original owner’s remaining life expectancy, whichever is longer. They can also adhere to the ten-year rule if the original owner had not started taking RMDs yet, although this is an option and not a requirement.
Tax implications of inherited IRAs
Inherited traditional IRAs come with strings attached in the form of taxes. However, inherited Roth IRAs come with a bit of a silver lining. Since the original contributions were made with post-tax dollars, distributions are typically tax-free. But there’s a catch: the account must have been open for at least five years. If not, the earnings will be subject to taxes, but the contributions made by the original owner remain tax-free.
Most beneficiaries are subject to a 10-year payout period for IRAs inherited in 2020 or later. If you fail to withdraw the full balance by the end of this period, you could face a penalty of 50% of the amount that should have been distributed.
Also, missing a required minimum distribution or taking less than the required amount results in a 25% penalty on the shortfall.
Strategic moves for inherited IRAs
Inherited IRAs might be complex, but they also come with many possibilities. Knowing the nuances can help you get the most out of your inheritance while sidestepping potential pitfalls.
You have the power of movement.
Just because you’ve inherited an IRA held by a particular custodian doesn’t mean you’re tied to them for life. If the investment options don’t align with your goals, or if you’re unsatisfied with the service, it’s possible to move your inheritance to a different custodian. But this needs to be done via direct transfer. This means funds must move directly between the institutions without you ever taking possession. Any indirect movement could be considered a taxable distribution.
It’s also imperative that the receiving account is explicitly labeled as an inherited IRA to avoid tax complications.
Consider your tax bracket.
If you’re on the cusp of a higher tax bracket in a given year, it might be wise to delay a distribution if you’re subject to the 10-year rule. Or, you could take a smaller distribution to avoid pushing yourself into that higher bracket.
Leverage charitable distributions.
If you’re 70 ½ or older, you may want to consider Qualified Charitable Distributions. You can transfer up to $100,000 annually from the IRA to a qualified charity, which will count toward your RMDs. The donated amount is excluded from your taxable income.
Consult a professional advisor
There are many variables when it comes to inherited IRAs, and each person’s situation is unique. While this article provides an overview of inherited IRAs, it is not a substitute for speaking with one of our expert advisors about your specific situation. Contact our office to discuss minimizing taxes and adhering to all IRS rules for your IRA.
