Inherited IRA Distribution Rules: Key Things for Beneficiaries to Know
An Individual Retirement Account (IRA) can be used as an estate planning tool. It allows you to pass on your hard-earned wealth and years of savings to your loved ones. But an IRA comes with rules. A lot of them! These rules may feel complicated and even frustrating. But they are there, and you cannot escape them.
The Internal Revenue Service (IRS) is very clear about how inherited IRAs must be handled. If you do not follow the inherited IRA distribution rules properly, you could lose a lot of your money to taxes and penalties. That is why it is better to understand the beneficiary IRA distribution rules before you inherit an IRA, not after.
Whether you currently own an IRA and plan to pass it on, or you have recently inherited one or know you will inherit one in the future, knowing how these distributions work is critical.
Let’s understand the existing beneficiary IRArules in this article.
Table of Contents
What are the distribution rules for an inherited IRA?
The inherited IRA distribution rulescan vary depending on the type of beneficiary.
1. Spouses
Let’s start with spouses and see what they need to do if they inherited a deceased spouse’s IRA. When a spouse inherits an IRA, they get a lot more control over the money than any other type of beneficiary. The surviving spouse can choose how and when to access the funds, but the decision depends on the spouse’s age and other factors, such as financial needs and tax obligations. Having said that, a surviving spouse can either treat the IRA as their own or hold it as a beneficiary IRA.
The rules differ depending on whether the original account owner had started with their Required Minimum Distributions (RMDs) before passing away. Here are some scenarios:
- If the IRA owner died before they started taking RMDs
Currently, IRA owners need to start RMDs at age 73. If the deceased spouse had not yet begun taking RMDs, the surviving spouse can roll the beneficiary IRA into their own IRA. In this case, RMDs are not required until the surviving spouse reaches age 73. The surviving spouse’s age will be the primary factor here. Based on their age, they can keep the money in the account and benefit from tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.
Alternatively, the surviving spouse can choose to remain a beneficiary and maintain the account as a beneficiary IRA. In this case, they may delay RMDs until the year the deceased spouse would have turned 73. This can be beneficial in some situations, particularly if the surviving spouse is younger than 59½ and may need to withdraw funds. Withdrawals from abeneficiary IRA are not subject to the 10% early withdrawal penalty.
Another option is to take a lump-sum distribution of the entire account balance. If the beneficiary IRA account is a traditional IRA, the distribution is generally fully taxable in the year it is taken. So, this can increase the inheritor’s annual taxable income. If it is a Roth IRA and the five-year holding requirement has been met, the withdrawal may be tax-free.
- If the IRA owner died while taking RMDs
If the deceased spouse had already begun taking RMDs, the surviving spouse must first ensure that the RMD for the year of death has been taken. If the deceased spouse did not withdraw the full required amount before passing, the surviving spouse is responsible for withdrawing the remaining amount by the end of that year. Post that, the surviving spouse again has the choice to treat the IRA as their own or continue as a beneficiary.
If they roll the account into their own IRA, future RMDs will begin when they reach age 73 and will be calculated based on their own life expectancy. If the surviving spouse instead remains a beneficiary, they must generally begin taking RMDs in the year following the year of their spouse’s death. These distributions are typically calculated based on the surviving spouse’s life expectancy.
2. Non-spouses
Non-spouse beneficiaries can include a child, grandchild, sibling, friend, or any other relative of the original account owner. Unlike spouses, non-spouse beneficiaries have fewer options.
They cannot treat the IRA as their own, and in most cases, the 10-year rule applies. The exact beneficiary IRA distribution rules depend on whether the original account owner had started their RMDs before passing away.
Let’s check out the different scenarios and what non-spouses must do in each:
- If the IRA owner died while taking RMDs
If the original owner had already begun taking RMDs, the beneficiary must first ensure that the RMD for the year of death has been taken, just like a spouse. If it was not fully withdrawn, the beneficiary is responsible for taking the remaining amount by the end of that year. After that, the rules depend on the beneficiary type.
IRAs have a 10-year rule, and most designated beneficiaries must follow this rule. The entire beneficiary IRA balance must be withdrawn by December 31 of the 10th year following the owner’s death. But this is a general rule, and designated beneficiaries have different rules they must follow based on their relationship to the account owner.
For a non-spouse beneficiary who is a minor child of the original owner, chronically ill, disabled, or someone not more than 10 years younger than the deceased, the RMDs must continue. In this case, the distributions are calculated based on the life expectancy of the insured or the original owner, whichever is longer.
- If the IRA owner died before they started taking RMDs
If the original IRA owner had not yet started RMDs, the rules again depend on the beneficiary’s type. Eligible designated beneficiaries can choose to stretch distributions over their own life expectancy rather than withdraw the entire balance within 10 years. This option allows the account to continue growing tax-deferred in a Traditional IRA or tax-free in a Roth IRA.
All other designated beneficiaries must follow the 10-year rule. Under this rule, the full account balance must be withdrawn by December 31 of the 10th year after the owner’s death. Now, something that a lot of people miss here is the fine print hidden beneath this rule. While you do need to withdraw the money within 10 years, you can do so at any time during that period. The only thing you need to be careful about is that the account should be completely withdrawn by the deadline. If not, there can be penalties and taxes.
3. Estates, trusts, and others
Not everyone leaves their IRA to a spouse, child, or friend. In some cases, the account may be left to an estate, a trust, or even an organization such as a charity. When the beneficiary is not an individual, the inherited IRA distribution rules are different based on a few factors, as explained below:
- If the IRA owner died before they started taking RMDs
If the original account owner passed away before beginning RMDs, the five-year rule typically applies when the beneficiary is an estate, certain trusts, or another non-individual entity. Under this rule, the entire beneficiary IRA balance must be distributed within five years of the owner’s death.
There are no annual RMD requirements during those five years, but the money must be completely withdrawn by December 31 of the fifth year following the year of death.
- If the IRA owner died while taking RMDs
If the original owner had already begun taking RMDs, the five-year rule still applies for non-individual beneficiaries in many cases. The account must be fully distributed within five years. However, depending on how a trust is structured, different rules may apply, so it is important to review the trust documents carefully. In this case, hiring a financial advisor can be helpful.
Factors to keep in mind if you have a beneficiary IRA
1. Your relationship to the original owner
Each beneficiary category must follow different distribution rules and timelines. Hence, your relationship with the deceased account holder plays a major role in determining your options ahead.
Spouses generally have the most flexibility and can choose to treat the IRA as their own or remain a beneficiary. Non-spouse beneficiaries, such as children, grandchildren, relatives, or friends, usually have fewer options in comparison. They are also subject to the 10-year rule.
Estates, charities, and trusts have even fewer options. They are subject to the five-year rule instead.
2. The original owner’s age
The age of the original account owner at the time of death is another critical factor. Their age decides whether they have already begun taking RMDs. If not, then you must start taking withdrawals. If the owner had started RMDs, you may need to continue distributions. If they have not yet begun RMDs, you may have to follow the 10-year or 5-year rule, depending on your relationship with the owner.
3. Penalties for not withdrawing the money on time
Inherited Roth IRA distribution rules differ when it comes to taxes because these accounts do not have any pending tax dues. However, RMDs are taxed as ordinary income in the year you receive them if the IRA is a traditional account.
The amount you withdraw is added to your taxable income and taxed at your applicable income tax rate. If you fail to withdraw the full RMD by the deadline, the IRS may impose a 25% penalty on the portion not withdrawn. However, if the mistake is corrected within two years, the penalty may be reduced to 10%. In certain cases, the penalty may also be waived.
4. Tax obligations depend on whether you claim a lump sum or make regular withdrawals
When you inherit an IRA, you may have a higher tax bill. A beneficiary IRA is additional income after all. And your tax bill can increase or decrease based on whether you opt for a lump sum or periodic withdrawals.
If you opt for a lump sum, the entire inherited IRA balance is withdrawn in a single year. For traditional IRAs, the full amount is taxed as ordinary income in the year it is received. So, a lump sum withdrawal will push you into a higher tax bracket. This, as you may have guessed by now, could result in a larger overall tax liability.
On the other hand, if you take regular withdrawals spread over many years, your annual tax burden would not be as burdensome. You may avoid moving into a higher tax bracket and reduce the overall tax impact.
Keeping up with inherited IRA distribution rules
The beneficiary IRA distribution rulesmay seem stringent and complicated, but all you need to do is identify your relationship to the original account owner – a spouse, non-spouse beneficiary, or a non-individual entity. This will determine which rules apply to you. Once you know this, the rest is a walk in the park.
Ideally, IRA owners should educate their beneficiaries in advance. However, if you were not guided through the process, you can still refer to reliable resources, such as this article, and understand the applicable rules.
Keep in mind that inherited IRA distribution rules can change over time. So, another thing you can do is consult a financial advisor. You can consider using our advisor directory to find a qualified professional who meets your financial needs. Advisors usually know the latest IRS rules and can better guide you based on your circumstances.
Frequently Asked Questions (FAQs) about IRA death distributions
1. What is the 10-year beneficiary IRA distribution rule?
The 10-year rule applies to non-spouse beneficiaries. The rule indicates that these beneficiaries must withdraw the entire balance of an inherited IRA by December 31 of the 10th year following the original account owner’s death.
2. What is the 5-year IRA death distribution rule?
The 5-year rule requires that the entire inherited IRA balance be withdrawn within 5 years of the original owner’s death. This rule applies to trusts, estates, charities, and similar entities.
3. Is an IRA a good estate planning tool?
Yes, an IRA can be a good estate planning tool. It allows you to secure your loved ones. It avoids probate and helps your family and friends carry on with their lives in your absence.
4. How do you nominate a beneficiary for an IRA?
To nominate a beneficiary, you must complete a beneficiary designation form. You can get this from your IRA custodian. If not, you can also nominate an individual in your will. However, keep in mind that the beneficiary form generally overrides a will.
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