Inheriting an individual retirement account (IRA) from a loved one or close friend can leave you with some questions. You might not be familiar with how IRAs work if you don’t have an account yourself. Working with a custodian can help you manage the inherited account. However, among all the rules involved, you mainly need to remember the rules for withdrawals. Here’s a breakdown of how it all works.
What Is an Inherited IRA?
An inherited IRA is an account passed down to an individual or entity, known as a beneficiary, after the original owner’s death. It’s also called a beneficiary IRA and could be any type of IRA, which is typically a:
- Traditional IRA: A traditional IRA is a retirement account with tax advantages. The owner’s contributions can be fully or partially tax-deductible, and the funds and earnings are not taxed until the owner withdraws them. A Simplified Employee Pension plan (SEP IRA) and Savings Incentive Match Plan for Employees (SIMPLE IRA) are common traditional IRAs that are inherited.
- Roth IRA: A Roth IRA also offers tax advantages. Because owners pay taxes before they fund the account, the contributions and earnings grow and can be withdrawn tax-free as long as the owner is at least 59 ½ years old and the account has been opened for at least five years.
- Self-directed IRA (SDIRA): An SDIRA is an account type opened through a custodial company. The owner can invest in alternative assets typically prohibited by the IRS, such as real estate, cryptocurrency or precious metals. An SDIRA can be a traditional or Roth account.
Inherited IRAs come with the same account benefits, depending on the account type. For instance, if the previous owner had a Roth IRA, your withdrawals from this account will remain tax-free and penalty-free, even if you’re under 59½ years old. However, you cannot make new contributions to the account since an inherited IRA is technically not your own. It is only “retitled” to you.
Who Can Be a Beneficiary?
The owner typically lists the beneficiary when opening a retirement plan, and they can be any person the owner wants to entrust the account to. Most people name their spouse or child as the beneficiary.
Your relationship with the account owner and the date of the account owner’s death affect the required amount you need to withdraw annually, also known as the Required Minimum Distribution (RMD). Rules can get complex with the inherited IRA’s RMD requirements. Depending on your beneficiary type, you may be able to take a lump-sum distribution, but you must include taxable distributions in your gross income.
Inherited IRA Distribution Rules for Beneficiaries
The Internal Revenue Service (IRS) offers guidelines on how beneficiaries are to treat inherited IRAs. Original account owners should calculate the RMD for each of their IRAs. If the account owner died before withdrawing the RMD for that year, then you should withdraw this particular amount yourself, that same year. The RMD for the following year changes depending on the inherited IRA RMD rules.
Rules for Eligible Designated Beneficiaries
Eligible designated beneficiaries include:
- The spouse and children of the original account owner
- Disabled or chronically ill persons
- Persons who are not more than 10 years younger than the owner
Spouse beneficiaries can become the new account owner, unlike other beneficiaries. This means if you’re the spouse, you can roll over the funds to your own IRA or a qualified employer plan, such as a 401(k). If you prefer to keep the account as an inherited IRA, then beneficiary IRA distribution rules apply. You won’t need to take an RMD. Additionally, if you’re the sole beneficiary, you can postpone distributions until your spouse would have reached 73 years old.
If your spouse passed before 2020 and before they were required to take the RMD, you can take distributions on the inherited account based on your life expectancy or follow the five-year rule. The five-year rule simply states that you must empty the account within five years after the account owner’s death. If your spouse passed after they started taking the RMD, you can continue taking distributions based on your own life expectancy.
For other designated beneficiaries, assuming the account owner has passed in 2020 or later, you should distribute funds from the account fully within 10 years, known as the 10-year rule. If the owner’s passing was before 2020, you must follow the five-year rule. You can choose the frequency of these distributions as long as you deplete the account by the required date.
Rules for Nondesignated or Estate Beneficiaries
If the account owner did not name a beneficiary for the IRA, the distributions will be taken by nondesignated or estate beneficiaries. The required beginning date of an account is the first date the account owner is required to take the RMD. Generally, this starts at age 73. If the owner dies before this date, the funds within the account should be distributed within five years.
Nondesignated or estate beneficiaries are not individuals, but entities. These could be estates, charities or nonqualified trusts.
Changes Due to the SECURE Act
The inherited IRA 10-year rule comes from the Setting Every Community Up for Retirement Enhancement Act (SECURE Act), which updated the distribution rules for some designated beneficiaries. The act was passed in December 2019, with implementation starting on January 1, 2020. Before this act, beneficiaries could stretch the period of receiving the assets from the retirement account based on their own expected lifetime, far beyond that of the original account owner. This strategy was known as the “stretch IRA.”
This change was made to avoid promoting intergenerational wealth transfer and encourage saving for retirement, as was the intent for the IRAs. Apart from the 10-year rule, the SECURE Act raised the RMD date from 70 ½ years old to 72, then increased it to 73 with the SECURE 2.0 Act.
Plan Your Next Steps With Accuplan Benefits Services
Unintentionally breaking IRA rules can mean penalties or disqualification. If you’ve recently inherited an IRA, we at Accuplan can help you navigate the complexities of managing the account. Whether you’re a spouse looking to roll over the funds to a new account or a minor needing a custodian for the IRA, you can count on our services to help you manage the funds your loved one left for you.
We have vast industry knowledge, having been in business for over 25 years. Moreover, we manage over 10,000 accounts with over 40,000 unique investments. Whether you’ve inherited a traditional, Roth or self-directed IRA, you can count on our accumulated expertise and best practices. If you’re ready to get started, sign up for an account today!
Disclaimer: Our information shouldn’t be relied upon for investment advice but simply for information and educational purposes only. It is not intended to provide, nor should it be relied upon for accounting, legal, tax or investment advice.
