Everything to Know About Inheriting an IRA

Inheriting an Individual Retirement Account (IRA) can be both a financial blessing and challenge. On the plus side, a substantial inheritance can significantly enhance your financial security, support your long-term goals, and potentially offer a steady stream of income. However, inheriting an IRA also brings complex tax implications that vary based on the type of IRA and your relationship to the original account owner.

Recent legislative changes have dramatically altered the handling of inherited IRAs, impacting withdrawal timelines and tax obligations. These new rules add layers of complexity, underscoring the importance of careful planning to make the most of your inheritance and avoid potentially costly pitfalls.

Recent Changes in IRA Inheritance Rules

The SECURE Act of 2019 brought about sweeping changes affecting how many beneficiaries handle inherited IRAs. One of the most impactful changes was the elimination of the “stretch IRA” for most non-spouse beneficiaries.

Previously, these heirs could stretch out distributions from an inherited IRA over their entire lifetime, allowing for extended tax-deferred growth and potentially lower tax bills. This strategy was particularly beneficial for younger heirs who could stretch distributions over many decades.

The SECURE Act introduced the 10-year rule, which applies to many future beneficiaries and those who’ve inherited IRAs since 2020. This new rule requires most non-spouse beneficiaries to deplete the entire inherited IRA within 10 years of the original owner’s death—a change that comes with significant financial planning implications.

Types of IRA Beneficiaries

When it comes to inheriting an IRA, the Internal Revenue Service (IRS) doesn’t treat all beneficiaries equally. Understanding which category you fall into is crucial, as it determines the rules you’ll need to follow, as well as your available options.

Spouse beneficiaries enjoy the most flexibility. If you’re inheriting an IRA from your spouse, you have unique options, including the ability to roll the inherited IRA into your own IRA. This special status allows for potentially more favorable tax treatment and distribution rules.

Non-spouse beneficiaries, such as children, siblings, or friends of the original IRA owner, face more stringent rules. While most non-spouse beneficiaries are now subject to the 10-year rule, there’s a special category—Eligible Designated Beneficiaries (EDBs)—which includes:

• Disabled or chronically ill individuals
• Individuals not more than 10 years younger than the IRA owner
• Minor children of the IRA owner (but only until they reach the age of majority)

EDBs are exempt from the 10-year rule and can still use the old “stretch IRA” method, taking distributions over their life expectancy. This can provide significant tax advantages and allow for extended growth of the inherited funds.

Rules for Spouse Beneficiaries

If you’re a surviving spouse who has inherited an IRA, it’s crucial to understand your options. Each has its pros and cons, and the best choice depends on your individual circumstances, including your age, financial needs, and overall retirement strategy.

First, you can roll over the inherited IRA into your own IRA. This approach can be advantageous if you’re under 59½, as it allows you to delay Required Minimum Distributions (RMDs) until you reach age 73 (as of 2023).

Rolling over the inherited IRA into your own IRA also enables you to name your own beneficiaries. However, be aware that if you need to access the funds before age 59½, you may face a 10% early withdrawal penalty.

Alternatively, you can treat the account as an inherited IRA. This option might be preferable if you’re under 59½ and need immediate access to the funds without incurring the 10% early withdrawal penalty. With this choice, you’ll need to start taking RMDs based on your life expectancy, you can delay them until your spouse would have reached age 73.

Rules for Non-Spouse Beneficiaries

The rules governing inherited IRAs for non-spouse beneficiaries have become more complex following the SECURE Act. The most significant change is the introduction of the 10-year rule, which applies to most non-spouse beneficiaries who inherited an IRA after January 1, 2020.

Under the 10-year rule, the entire balance of the inherited IRA must be distributed by the end of the tenth year following the year of the original owner’s death. This doesn’t mean you have to take distributions every year, but you must empty the account by the end of the 10-year period.

However, there’s an important caveat: if the original owner had already started taking Required Minimum Distributions (RMDs), the beneficiary must continue taking annual RMDs based on their own life expectancy, in addition to emptying the account within 10 years.

It’s crucial to note that there are exceptions to these rules for Eligible Designated Beneficiaries (EDBs). EDBs can still use the old “stretch IRA” method, which allows them to take distributions over their life expectancy, potentially spreading out the tax impact and allowing for continued growth of the inherited funds.

Understanding these rules is vital for effective tax planning and to avoid penalties. In particular, the 10-year rule can result in larger taxable distributions, so it’s important to strategize your withdrawals to minimize the tax impact while meeting the requirements.

Required Minimum Distributions (RMDs) for Inherited IRAs

The IRS has recently provided clearer guidance on Required Minimum Distributions (RMDs) for inherited IRAs, addressing some of the confusion that arose after the SECURE Act.

For most non-spouse beneficiaries who inherited an IRA from someone who had already started taking RMDs, the IRS now requires annual withdrawals. These RMDs must begin in the year following the original owner’s death, and you must take the first distribution by December 31st of that year.

To calculate RMDs for inherited IRAs, you can use Table I (Single Life Expectancy) in IRS Publication 590-B. There are also online calculators that can help with this calculation.

The penalties for failing to take RMDs on time can be steep. Currently, the penalty is 25% of the amount you should have withdrawn. However, if you correct the mistake promptly (generally within two years), the penalty can be reduced to 10%.

Remember, these RMD rules apply in addition to the 10-year rule for depleting the account. This means you must take annual RMDs for years 1-9, and then withdraw any remaining balance in year 10.

Tax Implications of Inheriting an IRA

The tax treatment of inherited IRAs differs significantly between traditional and Roth IRAs. Understanding these differences can help you identify strategies to manage your tax liability.

For traditional IRAs, withdrawals are generally taxed as ordinary income in the year you take them. This means that inheriting a large traditional IRA could potentially push you into a higher tax bracket, especially if you’re required to deplete the account within 10 years.

Roth IRAs, on the other hand, offer more favorable tax treatment. Specifically, withdrawals from inherited Roth IRAs are typically tax-free, provided the account has been open for at least five years.

To manage your potential tax liability, consider the following strategies:

• Spread out withdrawals over the allowed timeframe to avoid large spikes in taxable income.
• Coordinate IRA withdrawals with your other sources of income to manage your overall tax bracket.
• Consider taking larger distributions in years when you have lower income or higher deductions.
• If you have inherited both traditional and Roth IRAs, strategize which to draw from first based on your current and projected tax situations.

It’s wise to consult with a financial planner or tax professional who can help you develop a personalized strategy that’s aligned with your specific financial situation and goals.

Inheriting an IRA: Planning Ahead

For IRA owners, one of the most important aspects of planning is keeping beneficiary designations up to date. These designations supersede will instructions, so it’s vital to review and update them regularly, especially after major life events like marriages, divorces, births, or deaths in the family.

In addition, discussing your intentions and the potential implications of inheriting an IRA with your beneficiaries can help them better prepare for the future. This conversation can include explaining the basics of inherited IRA rules, potential tax implications, and your wishes regarding the funds.

For those who stand to inherit an IRA, it’s wise to incorporate this potential inheritance into your overall financial planning. Understanding how an inherited IRA might impact your financial situation, including tax obligations and long-term financial goals, can help you make more informed decisions when the time comes.

Managing Your Inherited IRA with Confidence

Managing an inherited IRA requires careful consideration and planning. By understanding the rules and developing a strategy that aligns with your financial needs and goals, you can make the most of your inheritance and avoid costly pitfalls.

Professional guidance can be invaluable when navigating the complexities of inheriting an IRA. If you stand to inherit wealth or simply want to ensure you’re maximizing your financial potential, SageMint Wealth is here to help. Contact us to learn more and begin your financial journey.