Most people look at their life expectancy and decide how to manage their retirement accounts accordingly. If they feel that their life expectancy still gives them a lot of time before they have to consider withdrawing from their retirement account, it will affect their decision-making process significantly.
However, life is not always so accommodating and an unexpected death can derail all the plans made using this life expectancy method. The result is often that eligible designated beneficiaries receive the news that an IRA account holder died leaving them with an inherited IRA to deal with.
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However, if you are the eligible designated beneficiary, you will soon find that there are certain rules regarding inherited IRAs that you need to deal with. You will have to consider, for example, the following:
The age of the original account owner in their year of death
Your relationship with the IRA owner
What type of IRA beneficiary you are
Whether you are younger than the original account owner and your life expectancy
Circumstances of the original owner’s death
Specific contribution and distribution rules governing an inherited IRA
Even if you never had plans to have your own IRA assets, inherited IRA accounts can fall on your lap unexpectedly. Read this article to find out how best to deal with inherited Roth and Traditional IRAs.
IRA assets from a deceased account holder are known as inherited IRAs or beneficiary IRAs. Funding for inherited IRAs can come from different sources, such as:
Simple and SEP IRAs
While most people with an inherited IRA find it easier to set up an account with the same custodian as the original account holder, you can use any eligible bank or brokerage firm.
With inherited IRA assets, you have to consider things like paying taxes using the income tax rate. This means you have to be very careful when naming your inherited IRA account. In most cases, it will be in your best interest to name the inherited IRA as follows:
[Recipient’s Name] Inherited IRA Beneficiary of [Name of the Deceased]
When it comes to deciding who inherits the Roth IRA or Traditional IRA, it is usually the person that is named in the IRA paperwork of the deceased account holder. This eligible designated beneficiary has a lot more weight than whoever may have been named in the will of the deceased.
In most cases, when faced with an unexpected inheritance, most beneficiaries find themselves with a lot of important decisions to make. While the same can be said about an inherited IRA, the number of options is somewhat limited.
All beneficiaries have the option to immediately cash out on their inherited Roth IRA. However, choosing to simply take a lump sum distribution from the inherited IRA and shut down the account will incur a lot of taxes.
Inherited IRA beneficiaries are, therefore, advised to explore the best way to try and meet the required minimum distributions (RMDS) while making sure the funds are withdrawn tax-free.
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An inherited IRA beneficiary can either be an eligible designated beneficiary, such as when a relative, friend, or spouse inherits the IRA, or a non-spouse beneficiary, such as trusts, charities, or estates.
The way you handle the inherited IRA depends on your relationship with the deceased account holder, as follows:
When a Spouse Inherits the IRA
Rules for the inherited IRA are much more lenient when the beneficiary is the spouse of the deceased. In this case, they have the option of either setting up a normal inherited IRA or the more advantageous option of simply treating the account as their own IRA.
If they choose the second option, a spouse can take advantage of the spousal transfer rules to roll over funds from the inherited IRA into an existing IRA in their name.
Everyone else who inherits a Traditional or Roth IRA has to set up a separate IRA account named in the manner we discussed earlier. Any further decisions on the inherited IRA will depend on specific circumstances, such as the relationship to the deceased and the life expectancy of the beneficiary.
Unless you want to find yourself on the wrong side of the IRS and risk incurring hefty tax penalties, there are certain rules and regulations that you have to pay attention to.
When it comes to handling an inherited Traditional or Roth IRA, there are two categories you cannot ignore concerning how you withdraw funds and make contributions.
The following are the two most important rules regarding an inherited IRA:
As a beneficiary, you have a certain degree of freedom regarding when you will choose to withdraw funds from your inherited IRA.
However, you have to empty the account sooner or later. While this rule does not apply to the original account holder, as the beneficiary you must meet the required minimum distributions (RMDS) otherwise you will be penalized severely.
This means the first thing you have to do when you inherit an IRA is to decide when you are going to cash out most advantageously in terms of paying taxes on the account.
Another important distinction between the beneficiary and the original IRA owner is that as the beneficiary you are not allowed to make further contributions to the inherited IRA.
The spousal transfer provides an alternative for a spouse to rollover the funds into their account that allows contributions but for all other beneficiaries making any further deposits to the inherited IRA is out of the question
Usually, the best you can do as a beneficiary IRA owner is to manage the account by buying and selling assets or making different investment choices using the funds already in the account.
Spouses of the deceased usually have the most flexibility when managing their deceased spouse’s IRA.
Besides having the option to withdraw money at any time like any other beneficiary, the spouse can also put the inherited IRA into their name or simply roll over the funds into an existing account.
One important consideration a spouse has to remember is the life expectancy and required minimum distributions rule that compels them to make withdrawals when they reach the age of 72.
The distribution rules state that they can make the same withdrawals their spouse would have been required to make or they can recalculate their distributions based on their life expectancy.
All other beneficiaries are allowed to make distributions at any time that they choose. However, the number of years they have to make withdrawals from the year of death of the deceased is 10. Early withdrawal will come with a huge tax bill but leaving it too late will also incur penalties.
As an example, if the account holder died in January 2020 and left their IRA to one of their friends as an inheritance, the beneficiary has until December 31 of the year 2030 to empty all assets from the inherited IRA.
While being left retirement accounts, such as inherited Roth IRAs is an unexpected source of funds that most people are glad to have, it can prove to be a headache for the sole beneficiary if not managed properly.
One thing that you have to watch out for when managing the retirement savings, you have received as an inheritance is the penalty for not making withdrawals at the appointed time.
As soon as a non-spouse beneficiary misses the 10-year deadline they will face hefty fines that will deplete the value of the retirement account significantly.
In most cases, the IRS will charge a 50% penalty on the value of the money in the IRAs inherited by the beneficiaries. This on its own can be a large sum when dealing with a sizeable IRA account and is something that should be avoided at all costs.
Another important aspect that has the potential to eat away at your inherited IRAs is the amount of tax you have to pay, especially in cases where the deceased fell into a higher tax bracket.
While the rules that applied to the deceased will also apply to the beneficiaries, one advantage is the funds will continue to grow tax-deferred or tax-free just as they used to. This freedom from income tax is one of the main advantages of inheriting a Traditional IRA or Roth IRA.
If the IRA you inherited has taxable withdrawals, such as Traditional IRAs, you will continue to be taxed according to your taxable income rate.
Inherited Roth IRA withdrawals will be tax-free but only in cases where the IRA account meets the five-year rule (the original account holder must have held the account for at least five years before they passed away and left it to you).
It might seem that the rules for inherited IRAs are very strict on beneficiaries, but there is one advantage that they can enjoy.
In usual circumstances, any withdrawals that an IRA owner makes before the age of 59 and a half will be penalized at 10% of the value of the retirement account. However, this 10% early withdrawal penalty is waived for beneficiaries of inherited IRAs.
Back in 2019, President Donald Trump signed into law the Setting Every Community Up for Retirement Enhancement Act, more commonly called the SECURE Act. This Act effectively removed the age restrictions on IRA contributions starting from the 2020 tax year going forward.
In terms of inherited IRA rules, the people most affected by this change are the non-spouse beneficiaries. Before the implementation of the SECURE Act, these beneficiaries could make annual distributions based on their life expectancy. This means for younger beneficiaries; the withdrawals and subsequent income tax payments could be very small amounts.
People looking for a good estate planning strategy soon realized the value of exploiting this rule by leaving their IRAs to younger beneficiaries.
The SECURE Act effectively put an end to this practice as beneficiaries are now required to empty all the money from inherited IRAs within 10 years of the year of death of the original account holder. There are however the following exemptions to the rules of the SECURE Act:
Disabled and chronically ill individuals
Direct descendants under the age of 18
Beneficiaries within 10 years of the age of the deceased
Beneficiaries under the age of majority will be subject to the 10-year rule as soon as they turn 18 years of age. All inherited IRAs that were set up before the implementation of the 2019 SECURE Act are allowed to follow the old rules governing IRA inheritances.
These are the key takeaways that beneficiaries should walk away with from this article:
Spouses have the most options regarding what they choose to do with their IRA inheritance
The best option for non-spouse beneficiaries is to transfer inherited retirement funds into an inherited IRA account
Withdrawals are flexible as long as they are made within 10 years of the year of death of the original IRA owner
The 10% early withdrawal penalty does not apply to beneficiaries
Leaving funds in place for more than 10 years from the year of death of the original IRA owner will incur a 50% penalty
The rules covered in this article are just the basics of what is a very complicated system. When dealing with such an inheritance situation, it is best to consult a tax professional to avoid having to pay any penalties in future.