The loss of a family member is difficult to deal with emotionally but handling the logistics of the inheritance and paperwork can be overwhelming. Inheriting an Individual Retirement Account (IRA) now comes with new strict rules and guidelines which every beneficiary should know about.
Beneficiaries
A named beneficiary (individual or trust) inherits the IRA, regardless of wills or other documents. It is important to keep these beneficiaries updated so your money goes to who you intended.
Eligible Designated Beneficiaries: These are beneficiaries listed on the IRA account and are also either: the spouse, the minor child of the deceased, an individual less than 10 years younger than the deceased (usually a sibling), or an individual that is chronically ill or disabled.
Designated Beneficiaries: These are beneficiaries listed on the IRA account but do not qualify as an eligible designated beneficiary listed above.
Trust/Estate: These are beneficiaries that were NOT listed on the IRA account but are a beneficiary per the deceased individual’s will or received it through a trust or estate. In this situation you should contact the estate executor or trustee to determine how your inheritance will be treated.
Distributions
Distributions from traditional IRAs are always taxable income. Since the contributions were made with pre-tax money there is no basis in these accounts and all growth has been income tax free. So, 100% of the distributions are taxable income to the beneficiary.
Rollovers
Each beneficiary can choose to roll over their portion of an inherited IRA to a rollover-IRA account. The roll-over itself is an income tax-free event. However, this inherited IRA should be kept in a separate account than other traditional IRAs since the distribution requirements are different from self-funded IRA accounts.
Spouses
Per the SECURE Act, spouses as listed beneficiaries are the only individuals who can roll their inherited IRA into their existing IRA. They would then follow the Required Minimum Distribution (RMD) rules for their account.
Inherited IRAs after 2020
With the passing of the SECURE Act and SECURE Act 2.0 of 2022, inherited IRAs (by a non-spouse beneficiary) must now be fully withdrawn within 5 or 10 years depending on the type of beneficiary:
Eligible Designated Beneficiary (see description above): These qualified beneficiaries can open an Inherited IRA account and take the distributions over time. The RMDs are based on their life expectancy timeline. Or they can take a lump-sum distribution and distribute the account all at once.
Designated Beneficiary (see description above, not an Eligible Beneficiary): These beneficiaries can open an Inherited IRA account and must distribute the entire balance within 10 years. If the original IRA account holder was taking RMDs, the designated beneficiary must take at least the RMDs each year during the 10-year period before taking the full balance. If the original owner had not reached RMD age when they passed away, then the designated beneficiary can distribute at any schedule as long as the full amount of the inherited IRA is distributed by the 10th year.
Trust/Estate: If an individual was not listed as a beneficiary of the IRA account, then the executor of the estate can take a lump-sum distribution or roll the IRA account into an inherited IRA. The estate will need to take RMDs on the inherited IRA if the original IRA account owner was taking RMDs, and the full balance of the inherited IRA must be distributed within 5 years.
Inherited IRAs before 2020 (pre-SECURE Act)
If you inherited an IRA from an individual who passed before 2020, the inherited IRA is not subject to the changes in the SECURE Act. This inherited IRA is subject to the prior distribution rules. If a taxpayer did not fully distribute the IRA within 5-years of the inheritance, they are subject to RMDs based on 2 schedules using the original owner’s age at their passing.
If the account holder was under 70 ½, the RMDs are based on the inheritor’s life expectancy and must begin the year after the passing.
If the account holder was 70 ½ or older, the RMDs are based on the original owner’s life expectancy.
Penalties
The penalty for not taking a RMD or distribution by the deadline is 25-50% of the required distribution amount. There is relief under Notice 2022-53 for a beneficiary who did not take the RMD for 2021 and 2022.
Inherited Roth IRAs
Inherited Roth IRAs are typically subject to the same RMD requirements; however, these qualified distributions are not taxable income.
We encourage our clients to make sure their IRA beneficiaries are kept up to date. If you have any questions about an IRA you have inherited and how it will impact your tax situation, please reach out to a member of our team.
Dana R. Borys, an Accountancy Corporation is a boutique tax consulting, compliance, and representation firm working with affluent individuals and start-up/emerging growth companies. Building connections beyond the code.