Navigating Inherited IRAs: A Guide to Inherited IRA Rules

We understand that facing significant life changes, such as inheriting an individual retirement account (IRA) amidst a personal loss can be a challenging experience. Understanding the ins and outs of the process and decoding the financial jargon related to inherited IRAs can feel overwhelming. That's why we are here to help you navigate the world of inherited IRA rules with confidence and clarity.

What Is an Inherited IRA?

An IRA, or individual retirement account, is a tax-advantaged vehicle to save for one’s retirement. When the original owner of an IRA passes away, the beneficiary inherits the IRA. This is where an inherited IRA comes in. An inherited IRA or beneficiary IRA is a distinct type of IRA that serves the purpose of transferring IRA funds from the original owner to their beneficiary.

The beneficiary of an inherited IRA could be a:

• Natural person
  • Spouse (spousal beneficiary)
  • Relative
  • Any other unrelated person
• Non-natural person
  • Trust
  • Estate
  • Organization, etc.

Inherited IRA rules vary based on several factors such as the type of beneficiary you are and the type of IRA you inherit. An inherited IRA may be one of the following:

• Traditional IRA
• Employer-sponsored IRA like a SIMPLE IRA or SEP-IRA
• Roth IRA
• Qualified retirement plan

Understanding the Classification of Beneficiaries

Before we answer the question regarding what your options are once you inherit an IRA, it is crucial to set the context surrounding inherited IRAs. The tax laws pertaining to inherited IRAs underwent significant modifications fairly recently with the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019. This Act, effective as of January 1, 2020, has had a profound impact on inherited IRAs. This was further built upon by the SECURE 2.0 Act of 2022.

Under the SECURE Act, beneficiaries are categorized into three distinct groups based on their relationship to the original account owner, their age, and whether they are individuals or non-person entities.

It is essential to know the capacity in which you inherited your IRA because your options will depend on the class of beneficiary you fall under.

Generally speaking, spousal beneficiaries have the most extensive range of options when it comes to dealing with inherited IRAs.

The three categories of beneficiaries are as follows:

• Eligible designated beneficiaries
• Designated beneficiaries
• Non-designated beneficiaries

Who is an eligible designated beneficiary (EDB)?

This is a person who was designated as a beneficiary on the account and is also one of the following:

• Surviving spouse

• A disabled or chronically ill individual

• Individuals not more than 10 years younger than the IRA owner

• Child of the IRA owner who is below the age of majority

  Note: A person is considered disabled if they fall within the scope of the definition of disabled in Section 72(m)(7) of the Internal Revenue Code (IRC):

  “...an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration”.

  _To qualify as chronically ill for IRA EDB (eligible designated beneficiary) purposes, an individual must meet the criteria outlined in IRC Section 7702B(c)(2). _

  If the person is certified as unable to perform at least two activities of daily living (without substantial assistance from another individual), such as eating, toileting, etc. and their illness is expected to be long-term and indefinite, they will be considered as meeting the definition of chronically ill.

Who is a designated beneficiary (DB)?

This is a person that was listed as the beneficiary on an IRA but is not one of the eligible designated beneficiaries you saw in the previous list.

Who are non-designated beneficiaries?

These beneficiaries are non-person entities that inherit IRAs. They do not have a life expectancy, as they are not living persons. In most cases, with the exception of trusts that qualify as eligible designated beneficiaries (EDBs) or designated beneficiaries (DBs), a non-individual beneficiary of an IRA, such as estates, charitable organizations, or non-qualified trusts, falls into the category of non-designated beneficiaries.

All beneficiary types have two common options for dealing with inherited IRAs:

• You can disclaim the inheritance, i.e., choose not to accept it (ensuring that all applicable laws are followed). If you do this, it passes on to the next beneficiary.
• Alternately, you can take the funds out in one lump-sum distribution.

What Are My Options?

As stated earlier, spouses (as distinct from all other eligible designated beneficiaries) have more options when it comes to dealing with inherited IRAs.

Inherited IRA Rules for Spouses

Designate yourself as the owner

If you're the surviving spouse and the only beneficiary of your late spouse's IRA, you have the choice to be treated as the owner rather than just the beneficiary of the account. This means you have control over the required minimum distribution, just like the original owner. This option becomes available when you elect or are acknowledged as the owner of the IRA.

As the surviving spouse, you have the power to step into the owner's role and decide how the distribution should be handled based on your own situation and preferences.

Transfer the funds to a new or existing IRA

The funds can be transferred to either an existing or a new IRA (of the same type as the inherited IRA) and treated as one’s own. What does this mean? If you, as a spouse, inherit a traditional IRA, you can transfer the funds into a traditional IRA, where the inherited funds will adhere to the rules and regulations of your specific retirement account. Consequently, these assets may continue to grow without being subject to taxes until withdrawal. As long as the distribution is not a required minimum distribution, you have a 60-day window from receiving the distribution to transfer it into your own IRA.

Which inherited IRA withdrawal rules apply to you (spousal beneficiary)?

• Access: You can access the funds whenever necessary. However, it's important to note that if you make withdrawals before reaching the age of 59½, you will be subject to a 10% early-withdrawal penalty.
• Required minimum distributions (RMDs) for spouses: Once you reach the age of 73, your retirement account will be subject to annual required minimum distributions (RMDs). The amount of the RMDs will be calculated based on your age and life expectancy, a method commonly referred to as the "stretch strategy." The IRS Uniform Lifetime Table life expectancy factors are utilized to determine the RMD amount.
• Tax advantages: Spousal beneficiaries can benefit significantly from this strategy, as it provides substantial tax advantages. By spreading out the withdrawals over an extended period, they can reduce their income tax burden. Why? Because distributions from IRAs are taxed based on marginal income rates, and by minimizing the annual withdrawal amount, spousal beneficiaries can effectively lower their taxable income.
• Unfulfilled RMDs: As the beneficiary of an inherited retirement account, you must note that if the original account holder had unfulfilled required minimum distributions (RMDs) before their passing, you are responsible for removing any remaining undistributed amount when transferring the funds to your IRA. In this scenario, the distribution and its associated tax liability will be attributed directly to you as the beneficiary, rather than to the original account owner or their estate.

Take a lump-sum distribution

You have the option to take a lump-sum distribution, which grants you access to the entire inherited amount. However, by choosing this approach, your funds will no longer grow tax-deferred, and it may push you into a higher income tax bracket, as the distribution will be subject to taxation.

Open an inherited IRA

You could open an inherited IRA and transfer the funds into that account. Required minimum distributions (RMDs) are compulsory, but you do have the choice to delay them until the latter of two options:

1. The year in which the deceased individual would have turned 73
2. December 31 of the year following the year of their death

However, do note that distributions must commence no later than December 31 of the year in which the account holder would have reached 73. This ensures compliance with the RMD requirements and the timely initiation of distributions.

Note:** **If you hold a traditional IRA or 401(k), once you reach a certain age, you're required to withdraw a minimum amount of money from these accounts each year. These withdrawals are called required minimum distributions (RMDs). From January 1, 2023, onward, the age at which this requirement kicks in is 73 years.

Inherited IRA Rules for Non-Spouses

Eligible designated beneficiary (non-spousal)

Suppose you are an eligible designated beneficiary (non-spousal), which means you are one of the following:

• A disabled or chronically ill individual
• Individuals not more than 10 years younger than the IRA owner
• Child of the IRA owner who is below the age of majority

Open an inherited IRA

You can open an inherited IRA and transfer the funds into it, allowing it to potentially grow tax-deferred. Here, the 10% early-withdrawal penalty does not apply, and you can access the funds.

If the original owner of the account passed away prior to December 31, 2019, the calculation of the required minimum distribution (RMD) will consider the age of the beneficiary, utilizing the single life expectancy factor.

If the beneficiary is a minor child of the deceased, when they reach the age of majority (usually 18, but this varies by state), the rules change to the 10-year rule.

Take a lump-sum distribution

You could also choose to take a lump-sum distribution. But do note that by making this decision, you forfeit the chance to benefit from potential tax-deferred growth in the future. Depending on the amount of the inheritance, this could result in your transition to a higher tax bracket.

Designated beneficiary

You can open an inherited IRA and take distributions over 10 years. The sole condition is that all the assets held in the account must be distributed within a period of **10 years **from the original owner’s death. During this timeframe, you have the flexibility to distribute the assets in any manner you want to. You can take a lump-sum distribution or in installments; however, it is important that you consider the tax implications of taking a lump-sum installment.

To whom does this 10-year rule apply?

The application of the 10-year rule is as follows:

• When the beneficiary is an eligible designated beneficiary and chooses the 10-year rule, and the account owner passed away prior to their required beginning date
• When the beneficiary is a designated beneficiary, irrespective of whether the account owner passed away before their required beginning date

If the beneficiary is receiving payments based on their life expectancy and falls into the category of either an eligible designated beneficiary or a minor child, the 10-year rule also governs the remaining funds in the IRA when the eligible designated beneficiary passes away or when the minor child beneficiary reaches the age of majority.

In these cases, the 10-year period ends on December 31 of the year that includes either the 10th anniversary of the original owner’s death, the eligible designated beneficiary's death, or when the child reaches the age of majority. If the funds are not withdrawn by the end of the tenth year, there is a possibility of a 50% penalty being imposed.

Who is exempt from the ten-year rule?

The following beneficiaries are exempt from the ten-year rule subject to the conditions mentioned above:

• Spouses
• Individuals not more than 10 years younger than the IRA owner
• Disabled or chronically ill individuals
• Minor children (until they attain majority) (Note: that this applies only to direct descendants, excluding grandchildren.)

Non-designated beneficiary

Depending on the age of the person who owned the retirement account before they passed away, the non-designated beneficiary will be subject to one of two rules.

If the account owner died before reaching the required minimum distribution (RMD) age, which is currently 73, the five-year rule applies. This means the beneficiary must withdraw the remaining balance of the account over a five-year period following the owner's death. There is no annual RMD, but the account must be emptied by the end of the fifth year after the owner's death.

On the other hand, if the owner died after reaching the RMD age, the payout rule is used. With this rule, the beneficiary can withdraw the remaining balance based on the owner's remaining life expectancy if they were still alive.

Each year, the beneficiary must take out a certain minimum amount (RMD), but they can choose to withdraw more if desired. In the case of a charitable beneficiary, they can receive the entire funds immediately without paying income tax.

RMDs for Inherited Roth IRAs

In general, the rules for required minimum distributions (RMDs) pertaining to traditional inherited IRAs apply to inherited Roth IRA accounts. When it comes to withdrawing contributions from an inherited Roth IRA, these withdrawals are not subject to taxes. Additionally, most withdrawals of earnings from an inherited Roth IRA are also tax-free. However, it's important to note that if the Roth account is less than 5 years old at the time of the withdrawal, the earnings may be subject to income tax.

Inherited IRAs and Custodial IRAs

A custodial account is established on behalf of a minor and overseen by an adult until the minor reaches the age where they can assume control of the account. The account always remains under the minor's name, and they can make contributions to it as long as they have earned income and adhere to the contribution limits imposed by the IRS.

On the other hand, an inherited IRA or beneficiary IRA is created upon inheriting an existing IRA. The primary function of this account is to hold the funds inherited by the beneficiary.

Key Takeaways

• An inherited IRA is a type of IRA that is opened when the original owner of an IRA passes away. It facilitates the transfer of IRA funds to the beneficiary.
• The three categories of beneficiaries are:
  • Eligible designated beneficiaries (EDBs),
  • Designated beneficiaries (DBs), and
  • Non-designated beneficiaries.
• Spousal beneficiaries have more options than other beneficiaries, including:
  • Becoming the owner of the inherited IRA,
  • Transferring funds to a new or existing IRA,
  • Opening an inherited IRA, or
  • Taking lump-sum distributions.
• The ten-year rule applies to certain classes of beneficiaries, requiring them to distribute the funds within ten years of the original owner’s death.
• Spouses, individuals within a decade of the deceased's age, disabled or chronically ill individuals, and minor children are exempt from the ten-year rule.
• Generally, the rules for required minimum distributions (RMDs) pertaining to inherited traditional IRAs also apply to inherited Roth IRAs.

Navigating inherited IRAs involves understanding the rules and options that apply to your specific situation. Whether you're a spouse or a non-spouse inheriting an IRA, familiarizing yourself with the inherited IRA withdrawal rules and RMD rules is crucial. By staying informed and seeking professional advice when needed, you can effectively manage your inherited IRA and make informed decisions for your financial future.