An individual retirement account or IRA is a tax-advantaged retirement account that individuals can open to save and invest in the long term. If the original IRA owner dies and an individual inherits that IRA, an inherited IRA is opened for the beneficiary. The beneficiary can be anyone including a spouse, relative, or unrelated party or entity (estate or trust).
When you inherit an IRA, you are free to withdraw as much money as you want without incurring a penalty at any time. However, you need to keep any potential income tax implications in mind when you withdraw funds from an inherited IRA. In addition, there are separate rules for withdrawing money in the case of the deceased owner’s spouse and a non-spousal beneficiary. To gain clarity on the aforesaid tax implications and rules concerning withdrawal of funds, do reach out to a professional financial advisor who can guide you on the same.
What is an inherited IRA?
An inherited IRA, also known as a beneficiary IRA, is an account that is opened in the name of a person who has inherited a tax-advantaged retirement plan (either an individual retirement account or retirement plan account) in the event of the death of the owner. The beneficiary of the inherited IRA could be a designated beneficiary like a spouse, offspring, relative, unrelated person, or an undesignated beneficiary like an entity (like a trust or estate). However, a spouse has the most flexibility in the use of an inherited IRA.
When the owner dies, the person inheriting the account can move the assets into a new IRA under their name. This is also the reason why an inherited IRA account is also called a beneficiary IRA.
Depending on the inheritor’s relation with the owner, there are a number of choices that the inheritor can pursue. Read on to find out more about them.
What are Inherited IRA distribution rules?
1. Regarding spouses
Spouses automatically receive ownership of the IRA upon the death of the owner. They are the default inheritors unless the owner appoints a different nominee. Spouses have the most control over the usage of the IRA when compared to other types of benefactors. To appoint a different nominee, the spouse must first sign a waiver. In case the owner is not married to their partner, they will have to specifically assign them as a nominee.
The spouse can directly appoint themselves as the owner instead of opening a separate inherited IRA account. They can also roll this over into another IRA that they already own. In addition, they can simply remain a beneficiary, but this option is not commonly preferred.
If the first option is chosen, the spouse will have to start taking required minimum distributions (RMDs) once they reach the age of 72 years. This also implies that the new owner can leave the money untouched and let it grow until they reach 72 years of age.
2. Regarding non-spouse inheritors
If you are a non-spouse inheritor, the rules of what you can do with the IRA differ a lot as compared to if you were a spouse. Unlike a spouse, you will not be able to become the owner of the account or roll it over to your own IRA. The only option is to make an inherited IRA account.
3. Regarding contributions
If you are only a beneficiary of the IRA, you can only manage the investments and buy/sell assets but you cannot make additional contributions of your own to it.
4. Regarding distributions
Depending on your relation with the original owner, you need to adhere to different rules with respect to the distribution of the funds. For instance, as a spouse, if you have inherited an IRA (Traditional or Roth), your options are as follows:
- You can treat the IRA as your own and appoint yourself as the owner. To do this, you could transfer the funds into a new or existing IRA. The distribution rules in this case will be just as how they would be if it was your own IRA. In this case, you must be at least 59.5 years of age to be able to make withdrawals without penalties.
- You can transfer the funds to an inherited IRA. In this case, you are required to have minimum required distributions which you can withdraw either according to the ten-year method or the life expectancy method.
- You can choose to have the IRA distributed to you in a lump sum amount. You will pay all the taxes at once and there will be no penalty for an early withdrawal. However, there is a risk that doing so would push you to a higher tax bracket.
- If you are not a spouse but are either – a minor child of the owner, chronically diseased or disabled individual, or are not more than 10 years younger than the owner (like a sibling, cousin, and so on), you will be considered as an eligible designated beneficiary.
- If you do not meet any of the aforesaid requirements and if the original owner deceased before 2019, you will be required to withdraw all the money from the account and pay tax on it within a decade from the date of death of the original owner. You may do so by opening an inherited IRA and begin withdrawals through life expectancy method or 10-year method.
- You can take out a lump sum distribution where you do not pay a penalty but may have to pay higher taxes.
What taxes are levied on an inherited IRA?
Since the contributions are made from pre-tax earned income, there are taxes applicable during the withdrawal period. You can formulate an optimal withdrawal schedule, keeping in mind the taxes that have to be paid besides avoiding penalties. You must be careful with this withdrawal schedule since withdrawing a large sum of money could push you to a higher tax bracket.
You might wonder if you can keep the money in your account forever and let it grow without having to pay any taxes. To prevent this, the government introduced required minimum distributions (RMDs). The owner of the IRA must start withdrawing a certain amount once they reach a certain age mandatorily as mandated by the IRS. If the owner fails to do so, they will be charged a penalty.
The RMDs start once a person turns 72 years old. At such a time, taxes on these must be paid, failing which a 50% penalty will be charged. The withdrawals are taxed according to the current tax rate of the beneficiary.
However, recently, due to the pandemic, most individuals had to dip into their savings to meet their daily expenses. To aid them in these tough times, certain stipulations were relaxed through the implementation of the SECURE Act in 2020.
Non-spousal beneficiaries were affected the most by the subsequent changes in rules. The SECURE Act, however, only holds for those individuals who deceased after 2020. Any person who inherited an IRA before 1st January 2020 is expected to follow the old rules.
According to the SECURE act, any non-spousal beneficiary (except minor children, disabled persons, etc.) is mandatorily required to withdraw all the money from the inherited IRA within 10 years. Previously, they had the option to withdraw funds from the inherited IRA according to their life expectancy. Now, since withdrawals are mandatory, the penalty that is usually charged for early withdrawal has been waived.
What are the differences between a Traditional IRA and a Roth IRA?
There are several types of IRAs like traditional, Roth, SEP, simple and so on. However, the most commonly preferred ones are traditional IRA and Roth IRA. The following table highlights the key differences between the two types.
|Basis of difference||Traditional IRA||Roth IRA|
|Tax contribution||A traditional IRA allows the owner to make contributions to the fund from their pre-tax income. This means that traditional IRA owners will be paying taxes at the time of withdrawal or distribution.||Roth IRAs are the flipped version of traditional IRAs. Here, the owner makes their contributions from their post-tax income. They do not pay taxes at the time of withdrawal.|
|Suitability||For those who expect to stay in the same or a lower tax bracket, even at the time of retirement or at the time of withdrawals. At the time of withdrawal, it is penalty-free and taxes are paid according to the current tax bracket if the person is over 59.5 years of age.||For those who expect their wealth and tax bracket to be at a higher level at the time of retirement or withdrawals.|
|Eligibility||Any person who has earned income can open and contribute to a traditional IRA||A person has to have their earned income below a certain level to be able to open and contribute to a Roth IRA|
|Minimum required distributions||Mandatory distributions of the IRA once the owner reaches 72 years of age.||No mandatory distributions even after the person reaches 72.|
Note: The type of the IRA cannot be changed while inheriting. A traditional IRA will be considered as a traditional inherited IRA and a Roth IRA will be considered as an inherited Roth IRA.
What are Inherited Roth IRA distribution rules?
Just like in the case of traditional IRAs, there are a few rules for the beneficiary of an inherited Roth IRA too. The main feature of Roth IRAs is that they have no minimum required distributions even after the owner reaches 72. This means that the beneficiary can leave the money untouched and let it grow or withdraw it and not face any tax consequences at all. Under older laws, one could keep an IRA for a lifetime without any consequences. But presently, only certain types of beneficiaries can avail of this perk. They are:
- Spouse of the owner
- Minor children of the owner
- Chronically diseased or disabled individuals
- Those who are not more than 10 years younger than the owner (like a sibling, cousin, and so on)
Other beneficiaries must distribute or withdraw all the assets in the account within a span of 10 years.
1. As a spouse, if you have inherited a Roth IRA, your options are:
- You can treat the IRA as your own and add yourself as the owner. To do this, you could transfer the funds into your new or your existing Roth IRA. The distribution rules in this case will be just as how they would be if it was your own Roth IRA.
- You can transfer the funds to an inherited Roth IRA. In this case, you are required to make minimum required distributions.
- You can choose to have the Roth IRA distributed to you in a lump sum amount. The contributions will not be taxed but the earnings will be if the IRA is not older than five years.
2. As a non-spouse beneficiary, you have the following options:
- You can open an inherited Roth IRA account under your name and transfer the IRA’s funds into it. In this case, the minimum distributions begin by 31st December of the year succeeding the year of death. Also, the account should be completely distributed and all assets must be sold within 10 years from the date of death of the original owner.
- You can open an inherited Roth IRA account under your name using the five-year method. Here, you would need to complete the distributions completely within 5 years before December 31st in the fifth year after the owner’s death.
- You can choose to have the Roth IRA distributed to you in a lump sum amount. The contributions will not be taxed but the earnings will be if the IRA are not older than five years.
Understanding the nuances of IRAs is paramount. It is crucial to assign a nominee to your IRA. In the absence of a nominee, the IRA gets clumped with the rest of your assets and the inheritors may lose out on any tax benefits that they could have availed. Apart from this, if you have inherited an IRA, it is critical to educate yourself about your potential options. It is advised to seek professional advice since IRA rules are fairly complicated to comprehend and you may need their help to understand the ensuing rules and regulations.
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