Do These 4 Things Now
The IRS has unique rules in place for those who inherit an IRA following the original owner’s death. If these rules aren’t properly followed, they can lead to big tax consequences for the beneficiary. Here’s what you need to do if you inherit an IRA.
#1 – Understand your options.
One straightforward rule that applies to all beneficiaries is that the tax treatment of the IRA remains the same from the original account to the inherited IRA. Traditional IRAs are treated as pre-tax accounts, and Roth IRAs are treated as after-tax accounts. Other than that, the tax rules for these accounts vary based on the type of beneficiary you are.
Spousal beneficiaries
A spouse who inherits an IRA typically has three options:
- Option 1: Elect to be treated as the owner of the IRA. By doing so, you’re viewed by the IRS as if you were the owner of the account all along. Only spousal beneficiaries have this option.
- Option 2: Roll over the inherited IRA funds into an existing retirement account.
- Option 3: Elect to be treated as a non-spousal beneficiary.
Non-spousal beneficiaries
Non-spousal beneficiaries don’t have the option of treating a traditional IRA account as their own. No contributions can be made to the account, and funds can’t be rolled into or out of the IRA.
However, non-spousal beneficiaries are permitted to open inherited IRA accounts. They can request a trustee-to-trustee transfer of IRA funds into an inherited IRA as long as the new account is established and maintained in the name of the deceased IRA owner for the sake of the beneficiary. For example, the account would be titled (Name of Deceased Owner) for the benefit of (Your Name). The trustee-to-trustee transfer allows you to move money directly from one financial institution to another without triggering taxes.
#2 – Follow the rules for distributions.
The Secure Act, which was signed into law in December 2019, requires that IRA beneficiaries distribute all account assets within 10 years of the account owner’s death (for IRAs inherited after December 31, 2019). There are no requirements for when within that 10-year period the money must be withdrawn. You can take it all out at once or take smaller withdrawals over time.
Starting January 1, 2025, if you inherit an account from someone who was already taking RMDs, the IRS will require you to start taking yearly RMDs from the inherited account.
There are a few exceptions to the 10-year rule for the following beneficiaries:
- Spousal beneficiary – If you chose to treat the IRA as your own, you must begin taking RMDs from a traditional IRA when you reach age 73. It’s important to note that if your spouse was subject to RMDs, you must take the required minimum distribution out for that year at the time of transfer. Once the funds are in your account, subsequent withdrawals will follow the rules of your IRA. You don’t need to take any withdrawals from a Roth IRA.
- Minor children – Minor children must take distributions based on their life expectancies until they reach age 18. At that time, the minor beneficiary must withdraw the entire account balance within 10 years.
- Chronically ill or disabled – These beneficiaries may stretch out IRA distributions over their lifetime.
- Those who aren’t more than 10 years younger than the account owner – These beneficiaries may stretch out IRA distributions over their lifetime.
#3 – Be aware of the five-year rule.
If you inherit a Roth IRA, you can withdraw contributions tax-free at any time. However, earnings may be taxable if the Roth IRA was less than five years old at the time of the original owner’s death. In this case, you’ll owe taxes on any earnings you withdraw. If the account was open for at least five years at the time of the owner’s death, earnings can be withdrawn tax-free.
#4 – Talk with your wealth manager.
As with many financial decisions, there are potential tax consequences or missed opportunities when you make an uninformed decision regarding an inherited IRA. Before taking action, consult with your wealth manager, who will help ensure any decisions make sense in light of your overall financial situation and goals for the future.
If you don’t have a wealth manager, we can help. Our experienced professionals work with clients to navigate a wide range of financial challenges and can help you make decisions in your best interests. Schedule a call to learn more.
For more information about beneficiary or inherited IRAs, visit IRS.gov.
