Inheriting an IRA: What You Need to Know
It’s no secret that saving for retirement is one of the smarter things you can do with your money. While social security may offer some financial benefits upon retirement (providing it’s even still around!), the distribution amounts are typically a fraction of the money needed to survive and more importantly, enjoy your post-career years.
For this reason, most people contribute some portion of their income to a retirement savings account. While these come in a variety of different flavors, including the popular employer-sponsored 401(k) and 403(b) plans, one of the most common is the Individual Retirement Account (IRA).
IRAs were first introduced in 1974 via the Employee Retirement Income Security Act (ERISA) and have become a popular retirement savings vehicle for generations of investors. There’s already a ton of great info about IRAs online so we’re not going to discuss the ins-and-outs of investing here. Rather, we’d like to focus on one very specific scenario that we get asked about all the time… what to do when you inherit an IRA!
When opening an IRA, the account holders generally name a beneficiary. A beneficiary can be any person or entity the owner chooses to receive the benefits of an IRA after they die. This may be a spouse, children, other individuals, a trust, charities or some combination of these entities. While most inheritances are tax-free to the heir, beneficiaries of an IRA must include any taxable distributions they receive in their reported gross income.
In rare cases where an IRA has no named beneficiary, the agreement held by the brokerage firm (custodian) should provide details on how the account will be handled in the event an individual dies. The agreement will either default to a "designated" beneficiary or an estate and be subject to the appropriate distribution rules.
I Inherited an IRA, Now What?
When the owner of an IRA dies, brokerage firms generally have systems in place for beneficiaries to follow – a process that usually starts by filling out a beneficiary claim form. Many firms also provide information about inherited IRAs including information about Required Minimum Distributions (RMDs) and the tax consequences of withdrawing funds early.
The Internal Revenue Service (IRS) also provides important taxpayer information for beneficiaries of inherited IRAs and other retirement accounts. However, because there are some fairly significant income tax and estate planning implications of inheriting an IRA, we strongly recommend consulting with one of our licensed tax specialists to help you navigate the complex distribution process.
Show Me the Money!
People who inherit IRAs often ask us when and how they can withdraw money from the account – and when they’re required to take a distribution. IRS rules regarding distributions are influenced by a number of factors, including the following:
Age. As with IRAs in general, age can be a factor that influences RMD payments, potential penalties and other aspects of inherited IRAs. For example, whether the account holder dies before or after 70½ (the age the IRS requires you to take minimum withdrawals from a traditional IRA) has implications for beneficiaries of inherited IRAs. Age 59½ is also an important age, especially for surviving spouses who decide to roll the account balance into their own IRA accounts (traditional or Roth) and subsequently withdraw the funds. If the spouse seeks to withdraw any of the funds before reaching age 59½, a 10 percent early withdrawal penalty will likely be applied.
Account type. The type of IRA (traditional or Roth) that is inherited is another key factor influencing distributions. With any inherited IRA, you generally must take distributions during your lifetime or within five years after the death of the original account holder. If you inherit a Roth IRA, you don't pay taxes on distributions (although earnings generally will be taxable if withdrawn before you are age 59½ and until a five-year holding period has been met). If you inherit a traditional IRA, you'll generally pay taxes on the distributions you take in excess of the deceased account holder's basis, which will depend on whether the decedent's contributions were deductible or nondeductible.
Relationship. Perhaps the most important factor influencing the distributions of an inherited IRA is the relationship of the account holder to the beneficiary. Different rules and options for handling the inherited IRA apply to spouses and non-spouses, which are discussed in more detail below.
When a Spouse Inherits an IRA
Most commonly, a surviving spouse is the named beneficiary of an IRA and will inherit the retirement account. Individuals in this situation have a number of options:
Treat the inherited IRA as yours by designating yourself as the account holder. In short, you create a new IRA in your name. The IRA (traditional or Roth) becomes yours, and RMDs are determined as if you were the owner beginning with the year you elect or are deemed to be the owner.
Treat the inherited IRA as yours by rolling it into a traditional IRA you already hold or into a qualified employer plan such as a 401(k) or 403(b) set up in your name. The assets are then treated as your own.
Treat yourself as the beneficiary (as opposed to becoming the account holder). In essence, you create an "inherited IRA," into which the assets of the original IRA are transferred. Depending on the age of the original account owner upon death, you can elect to take distributions over your own or the original account owner's life expectancy, sometimes referred to as the "life expectancy method," or over a five-year period.
Take a lump-sum distribution.
You may incur taxes on the distribution for a traditional IRA.
For a Roth, only earnings are taxable if the account is less than five years old at the time of the account-holder's death.
You will not incur a 10 percent early withdrawal penalty even if you are under age 59½.
Decide not to take ownership of all or part of the IRA. This is referred to as "disclaiming" or "renouncing" the inheritance. There may be estate or tax reasons for making this decision so it's very important you consult with an attorney to ensure legal requirements are met.
When a Non-Spouse Inherits an IRA
Another common situation is when an IRA is left to the deceased’s children, a friend, an estate or a qualified charity. However, unlike inheriting an IRA from a spouse, options are more limited:
Transfer the assets into an inherited IRA in your name. Non-spouse beneficiaries cannot treat an inherited IRA as his or her own (as spouses can). As such, they can't make any new contributions to the IRA or roll over any amounts into or out of the inherited IRA. The IRS does, however, allow for moving the IRA to another firm via a trustee-to-trustee transfer that meet certain conditions.
If you inherit a traditional or a Roth IRA, RMDs are mandatory. Distributions must begin no later than December 31 of the year following the death of the original owner of the IRA, or over a five-year period. It’s important to note these distributions may have significant tax implications, such as landing you in a higher income tax bracket.
Take a lump-sum distribution (same as spouse option).
You may incur taxes on the distribution for a traditional IRA.
For a Roth, only earnings are taxable if the account is less than five years old at the time of the account holder's death.
You will not incur a 10 percent early withdrawal penalty even if you are under age 59 ½.
Decide not to take ownership of all or part of the IRA (same as spouse option) by "disclaiming" or "renouncing" the inheritance. As for spouses, there may be estate or tax reasons for doing so, and it's important to consult with an attorney to ensure legal requirements are met.
IRAs with Multiple Beneficiaries
In cases where an IRA has multiple beneficiaries – a spouse and a child, for example – it's generally recommended that beneficiaries set up separate accounts. If separate accounts are not established, the amount of the required distributions for all beneficiaries are determined based on the age of the oldest beneficiary.
Since required distributions are based on life expectancy, the younger you are, the less you are required to take annually. This is a key reason we tend to counsel setting up separate accounts for each beneficiary.
Consult a Tax Professional
If you’ve inherited an IRA, it’s strongly recommended you consult a qualified tax specialist… like us! While the brokerage firm managing an IRA should be able to provide general information about the account and their own internal policies, the state and federal laws that apply to retirement accounts are constantly changing. We know the rules, understand tax law and have the most current information about what distribution options may be available for your specific situation.
If you need assistance or have questions about an IRA you’ve inherited, please contact us today for a FREE consultation. We’re here to help!