Inheriting an IRA? Understand Your Options and the Rules Around Them.

Prior to 2020, anyone who inherited a traditional IRA could “stretch” the account: a strategy designed to limit required distributions and help avoid sizable tax bills. More specifically, an account holder could name his/her children or grandchildren as beneficiaries, thus extending the lifespan of the IRA—and tax-deferred growth—for potentially decades beyond the life of the original accountholder.

When SECURE Act 1.0 (in 2019) and its 2.0 counterpart (in 2022) were subsequently passed, this marked the “death” of the stretch IRA. Consequently, most people no longer have this exact option but do have a few others we’ll outline in this post.

Inherited IRA rules: a broad overview

Generally speaking, designated beneficiaries—those who aren’t a spouse, minor child of the deceased owner, chronically ill or disabled, and/or more than 10 years younger than the account owner—must follow the 10-year rule when inheriting an IRA.

The 10-year rule requires you to withdraw funds from the inherited account within 10 years of the IRA owner’s death. If the IRA owner passes away in 2024, for example, funds in your inherited IRA must be fully distributed by December 31, 2034 (after which the account must be closed). During this 10-year period, beneficiaries can take distributions of any amount and at any frequency.

In most states, once a child reaches the age of 18, he or she is also subject to the 10-year rule.

Chronically ill or disabled beneficiaries, as well as those no more than 10 years younger than the deceased (on the date of death), can still stretch IRA distributions out over their lifetime rather than follow the 10-year rule. To be considered “disabled,” you must meet rules outlined in IRC Section 72(m)(7). To fall under the “chronically ill” category, meanwhile, you must be unable to perform at least two of six activities of daily living (ADLs)—eating, toileting, transferring, bathing, dressing, and continence—for a period of 90 days.

Inherited IRA rules if you’re the spouse and sole beneficiary

If you’re the sole beneficiary of your spouse’s IRA, you have a few options including withdrawing assets as a lump sum, transferring inherited assets into your own IRA (new or existing), transferring the funds into an inherited IRA held under your name, or converting inherited assets into a Roth IRA.

The most straightforward option is a lump sum scenario, wherein you withdrawal the entire balance at one time. In this case, keep in mind you’ll be subject to income taxes on that amount and the transaction could bump you into a higher tax bracket: meaning you’ll pay more taxes than you originally assumed.

A second option—sometimes advantageous if your spouse was older when he/she passed, as you can delay distributions until age 73—is to roll over the inherited assets into your own IRA (new or existing account), following standard IRA rules. More specifically, you may be able to make pre-tax contributions that can grow tax-deferred and name your own beneficiary on the account. However, required minimum distribution (RMD) rules also apply once you reach age 73, based on your age and life expectancy. If you’re not already aware, RMDs are the minimum amount of money one must withdraw from specific tax-deferred retirement accounts beginning at age 73 (climbing to age 75 in 2033). Should you make a withdrawal before age 59½, you’re still subject to the 10% early withdrawal penalty.

A third option is to transfer funds into an inherited IRA held under your name, which is typically a good choice if you were older than your spouse when he/she passed away (prior to age 73). The reason why? You can delay taking RMDs until your spouse would have turned 73. This option is also appealing to widows who need to access funds and are younger than age 59½, as the 10% early withdrawal fee doesn’t apply to these accounts. On the flip side, one of biggest drawbacks of this approach is that your IRA won’t be protected from creditors in federal bankruptcy law.

Finally, you also have the option to convert inherited assets into a Roth IRA. However, you’ll need to remain aware of tax implications—as taxes will apply to the converted amount. That said, this is often a good option for some investors such as those who wish to avoid RMDs and leave their heirs a tax-free inheritance.

Inherited IRA rules for spouses/multiple beneficiaries

If you’re a spouse but not the sole beneficiary, you (and all other beneficiaries) are required to transfer assets into a new inherited IRA by December 31st of the year following the year of death. If multiple beneficiaries fail to establish separate accounts by this deadline, all beneficiaries must take RMDs based on the beneficiary with the shortest life expectancy (or oldest beneficiary)—beginning in the year after the owner’s death. As a potential impact, younger beneficiaries are subject to a shorter payout period because the older you are, the shorter your distribution period.

Inherited IRAs: trusts, entities, & charities

If the IRA beneficiary is a “non-designated beneficiary” (such as a charity organization, estate, or non-qualifying trust), distributions are based on the age at which the original owner passed away.

For example, if the original owner passed after the age of 73 (or was alive on April 1st of the year he/she would turn 73), distributions are based on the remaining single life expectancy.

If he/she was younger than age 73, meanwhile, assets must be completely distributed by December 31st of the fifth anniversary of the original owner’s death: otherwise known as the “5-year rule” (note that 2020 is not included in this 5-year period).

Other inherited IRA considerations

Another option beneficiaries enjoy with an inherited IRA is the ability to disclaim the inheritance. By not accepting the inheritance (you must do so within nine months of the original owner’s death), you can allow the assets to pass to an alternate beneficiary named by the original account holder. This option is primarily utilized by those who don’t need the assets or don’t want the additional income due to potential tax consequences.

Inheriting a Roth IRA

Generally, inherited Roth IRA accounts are subject to the same rules as traditional IRAs. For example, only spouses, minor children of the deceased, those who are either not more than ten years younger than the deceased, disabled, or chronically ill can hold inherited funds in a Roth IRA for more than ten years. All other Roth IRA heirs must distribute all the assets in the account within ten years of the original owner’s death.

In summary: what you should know about inherited IRAs

Laws surrounding inherited IRAs grew more complicated when the SECURE Act 1.0 and 2.0 were passed in December 2019 and 2022, respectively. Corresponding mistakes are often very costly, so you certainly don’t want any surprises come tax time. It’s therefore imperative you partner with a trusted financial advisor who can guide you through options unique to your own personal financial situation as it relates to this topic.

Still have questions about an inherited IRA? Schedule a FREE Discovery call with one of our financial advisors.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.