What beneficiaries should know about their Inherited IRA

Inheriting an individual retirement account (IRA) could be a potential windfall, but these Inherited IRAs may also come with certain requirements to withdraw money that could impact your taxes or lead to potential penalties if left untouched.

Here, we answer questions often asked by clients about these accounts, including beneficiary distribution options, required minimum distributions (RMDs), and tax considerations depending on if the account inherited is a Traditional IRA or a Roth IRA.

What happens when an IRA owner passes away?

After the passing of the account owner, the beneficiary of the assets has three options:

• Take a lump-sum distribution
• Transfer the account into an Inherited IRA and take distributions in accordance with beneficiary status
• Disclaim the inheritance, partially or fully, within nine months of the date of death

Each of these options may have considerable effects on the beneficiary’s tax planning, and it is highly recommended that a tax advisor or attorney is contacted throughout the process.

How could an Inherited IRA affect my taxes?

When a beneficiary chooses to transfer Traditional IRA assets into a Traditional Inherited IRA, distributions from this Inherited IRA are generally seen as taxable income. Depending on the beneficiary’s situation, there may be a required minimum distribution (RMD) that must be withdrawn annually.

Distributions from these Inherited IRAs do not include a 10% premature distribution penalty, even if the beneficiary is below age 59.5. Additionally, keep in mind that Roth conversions from an Inherited IRA are not allowed (spouses can be an exception).

What are the different types of Inherited IRA beneficiaries?

IRA beneficiaries are separated into three categories, with distribution options mainly depending on year of death, the IRA owner’s age at death, and the relationship between the IRA owner and beneficiary. A tax advisor should be consulted to confirm beneficiary status and distribution options:

• Eligible Designated Beneficiaries (EDB): Individuals who are either the surviving spouse, not more than 10 years younger than the IRA owner, or a minor child of the IRA owner. Primary beneficiaries of “look-through” trusts who fall under any of these categories are also included. Examples of EDB beneficiaries are parents, siblings, and minor children. These beneficiaries can typically choose between the 10-year rule and Single Life Expectancy RMDs.
• Designated Beneficiaries (DB): Non-spouse individuals more than 10 years younger than the IRA owner, not disabled or chronically ill. Primary beneficiaries of “look through” trusts who fall under these categories are also included. Examples of beneficiaries are adult children, nephews/nieces, or other younger non-relatives. These beneficiaries are typically subject to the 10-year rule.
• Non-Designated Beneficiaries (NDB): Non-person entities including estates, non-look through trusts, and charities. These beneficiaries are typically subject to either the 5-year rule or life expectancy RMDs.

What is the 10-year rule?

Established by the 2019 SECURE Act, affecting deaths in 2020 or later, the 10-year rule requires certain Inherited IRA beneficiaries to withdraw all account funds within 10 years, with the year after death counting as the first year.

If the original IRA owner had already reached the required beginning date (RBD) for RMDs, currently April 1 of the year after turning 73, then the beneficiary must take annual RMDs throughout the 10-year rule. On the other hand, if the original IRA owner had not reached their RBD, the beneficiary does not have RMDs throughout the 10-year rule.

Keep in mind that beneficiaries can withdraw money at any point throughout the 10 years and often choose to withdraw more than the RMD amount in order to spread tax liability more evenly over the years. A tax advisor should be consulted about this.

Inherited Roth IRAs subject to the 10-year rule do not include RMDs, regardless of original IRA owner’s death. Qualified distributions are tax free, and beneficiaries often wait until year 10 to withdraw the full balance.

How are spouse beneficiaries treated?

Surviving spouse beneficiaries have the most flexibility when inheriting an IRA. They can use the 10-year rule, take RMDs based on Single Life Expectancy, or claim the IRA as their own Traditional IRA. Each of the options can be beneficial to the spouse depending on several factors discussed with the tax advisor.

How can IRA owners help minimize the tax liabilities of an Inherited IRA?

It is recommended that estate planning conversations take place while the original IRA owner is still living. Several strategies, including Roth conversions and Qualified Charitable Distributions (QCDs), can be taken advantage of to lessen the burden of taxes for the IRA’s beneficiaries. Working with a financial advisor, tax advisor, or attorney on these topics can be helpful to the whole family.