Individual Retirement Accounts [IRAs] provide significant tax advantages, but money can’t remain tax-deferred forever. The IRS requires account holders to take Required Minimum Distributions [RMDs] after a certain age from their own accounts, and beneficiaries of IRAs are also subject to these minimum withdrawals.
RMD guidelines for inherited accounts are intended to ensure that the money is withdrawn over a specified period. However, those rules were changed in 2020 through the SECURE Act, and anyone who is planning to leave money to their heirs or expects to receive money from a loved one should understand the new withdrawal requirements.
Rules For IRAs Inherited Before 2020
In the past, leaving an IRA to a loved one provided the opportunity for them to engage a strategy called a “stretch IRA.” It allowed any beneficiary to take relatively small distributions each year based on their life expectancy and keep the majority of funds in the tax-advantaged account throughout their lifetime.
The options for beneficiaries depended on whether the original account owner had reached the required beginning date before their passing. This is the date on which they would have begun RMDs.
Spouse Beneficiary
Spouses who inherited assets before the original account owner’s required beginning date had two options. First, they could rollover the account into their own IRA and follow the rules for that account. Second, they could choose to leave the account as an inherited IRA and either take distributions based on their own life expectancy or employ the 5-year rule. The 5-year rule didn’t require annual distributions, but the entire account had to be withdrawn within the 5-year timeframe.
If the original account owner passed away after beginning RMDs, the spouse only had the option of leaving the funds as an inherited IRA. They were required to take distributions according to their life expectancy table and were not allowed to employ the 5-year rule.
Non-Spouse Beneficiary
Non-spouse beneficiaries had similar options to spouses, minus the option to rollover the funds into their own IRA. If they inherited the assets before the original owner’s required beginning date, they could choose to withdraw according to their own life expectancy or employ the 5-year rule. If they inherited the assets after the required beginning date, they had to take distributions based on the longer of their own life expectancy or the original account holder’s life expectancy table.
Current Inherited IRA Rules For Spouse Beneficiaries
The old rules provided significant tax benefits for beneficiaries by allowing them to leave the assets in the account for an extended period of time. However, the IRS could not collect taxes in many cases. The SECURE Act addressed that issue by limiting the opportunity to leave funds in an inherited IRA. Fortunately, they included many provisions that protect spouses and preserve their ability to avoid taxation until retirement.
New Rules for Spouse Beneficiaries
Like the previous rules, the new inherited IRA rules allow spouses to rollover an inherited IRA into their own account, if the assets are inherited prior to the original account owner’s required beginning date. Spouses also have the option to keep the assets as an inherited IRA and delay distributions until the original owner would have turned age 72. They can also choose to take distributions based on their own life expectancy or utilize the new 10-year rule. The 10-year rule requires beneficiaries to deplete the account by the end of the 10th year after the account holder’s death and take annual distributions if the deceased account owner had reached RMD age before their passing.
The new rules expand a spouse’s ability to rollover funds into their own IRA to include situations where the original account owner had already begun RMDs. The surviving spouse can also choose to leave the assets in an inherited IRA and take distributions based on their own life expectancy.
Inherited IRA Rules For Non-Spouse Beneficiaries
The SECURE Act had an even more profound impact on non-spouse beneficiaries. The act introduced a special class of non-spouse beneficiaries called eligible designated beneficiaries, which includes a minor child, disabled or chronically ill individual, and an individual not more than 10 years younger than the original account holder.
Eligible designated beneficiaries have the option to take distributions over the longer of their own life expectancy and the original account holder’s life expectancy. They can also choose to employ the 10-year rule if they inherited the assets before the original account holder’s required beginning date.
Non-eligible designated beneficiaries – individuals who do not meet the criteria to be an eligible designated beneficiary – must use the 10-year rule. Additionally, beneficiaries who are not individuals – such as certain trusts, an estate, and charities – follow the pre-2020 rules since the SECURE Act changes only apply to individual beneficiaries.
The rules surrounding inherited IRA RMDs can be confusing. Refer to the following graphic for an overview of the options.
Income Tax Consequences of Distributions of Inherited IRAs
While the rules surrounding distributions from an inherited IRA changed with the SECURE Act, the tax consequences of those withdrawals remained the same. These withdrawals are generally subject to the same rules as IRAs that are not inherited.
Distributions from Traditional IRAs are generally subject to income tax on both the original amount invested and the accumulated earnings. These taxes are paid by the recipient of the funds on the amount distributed each calendar year. Amounts that remain in the IRA and are not distributed are not subject to income tax until they are withdrawn.
This article focuses solely on inherited Traditional IRAs. Due to the complexity of Roth IRA rules, they are not covered here. If you have an inherited Roth IRA, contact an experienced financial advisor for guidance.
Make Sense of Your Inherited IRA With Meld Financial
The rules surrounding inherited IRA distributions are complex and can have significant income tax considerations. If you have inherited a plan, discuss your options with our team at Meld Financial.
We specialize in retirement planning and have developed a proprietary wealth management program called Financial Fingerprint®. This nimble plan brings together the most important aspects of your financial life – including inherited IRA distributions.
To learn more about Financial Fingerprint® or discuss your personal situation, contact us today.
