Inherited IRAs - I

Individual Retirement Accounts first became available in 1975, and in the 50 years since they have become a major part of how Americans build wealth and save for their golden years. It is estimated that over $13 trillion is currently invested in these accounts, much of it owned by seniors who will eventually pass it on to younger generations.

Anyone inheriting an IRA faces a complex set of requirements and tax considerations for distributing the assets. Requirements can vary depending on the type of IRA, the year the IRA owner died, the ages of the decedent and beneficiaries and their relationship to each other. 

Before moving ahead with one of the many distribution choices, GEM recommends consulting with a finance or tax professional to fully understand your options.

Over several segments this summer, we will look at the basic rules for when an IRA is inherited, as well as planning considerations both for the beneficiaries who inherit the accounts and for the original owners who would like to maximize the benefit to their heirs.

The Basics — Traditional IRAs are tax-deferred accounts in which contributions are deducted from income and not taxed, the funds and the investment returns the account earns are not taxed until withdrawn. Roth IRA contributions come from income after being taxed, but the retirement distributions are tax-free. The IRS requires that after inheriting IRA assets, beneficiaries take distributions from the account.

• TIP #1 — Be sure your retirement accounts have named beneficiaries, otherwise the account will be required to go the probate process.
• TIP #2 — Each beneficiary will set up their own inherited IRA account to receive the assets, and the distribution requirements will be unique to them.

Types of Beneficiaries — The required minimum distributions (RMDs) from the account vary depending on the type of IRA and the beneficiary. Generally, beneficiaries are required liquidate the account within 10 years and may be required to take annual distributions if the decedent was taking them when they died. (Note: if the account owner passed in 2019 or before, non-spouse beneficiaries had the option of taking distributions over their own lifetimes).

There are exceptions for certain eligible beneficiaries:

• Spouses — If the surviving spouse is a primary beneficiary, they may assume the IRA assets and them to their own IRA. Then, the required distributions (if any) would be calculated on their own life expectancy. Alternatively, the surviving spouse may choose to re-register the IRA as an inherited IRA to avoid early distribution penalties depending on whether the deceased spouse was taking required distributions.
• Other Eligible Beneficiaries — Specific exceptions to these rules are available to non-spouse beneficiaries that are the account owner’s minor child or grandchild, disabled or chronically ill, or less than 10 years younger than the decedent.

Important — If the account is liquidated and the funds are distributed, there is no 60-day option to rollover the funds to another IRA. Generally, the amount will be subject to state and federal taxes as ordinary income. This would be in addition to any  taxable income amounts if the beneficiary is still working potentially, potentially making the funds taxable at a higher rate. Further, if the beneficiary is not yet 59 1/2, a 10% penalty for early withdrawal may also be assessed.

The Big Picture — Over the last 50 years, IRAs have become powerful vehicles for saving and building wealth. Despite the complexity of rules and options, they are a dependable option for most people.

The next segment of this series will explore options for a beneficiary to leverage an Inherited IRA to create advantages in their own planning. After that, we will consider ways an IRA owner could structure their retirement accounts to preserve more wealth and to optimize the financial legacy they leave.