Inherited IRA

An Inherited Individual Retirement Account (IRA), sometimes referred to as a Beneficiary IRA, is an account that is opened when someone inherits an IRA from a deceased individual. It allows the beneficiary to continue to benefit from the tax-deferred growth of the account, but there are specific rules regarding distribution and account management that beneficiaries must follow.

Types of IRAs that Can Be Inherited

There are several different types of IRAs that can be inherited:

Traditional IRA: Contributions to a Traditional IRA may be tax-deductible, and the investments within the account grow tax-deferred. Withdrawals made during retirement are taxed as ordinary income.
Roth IRA: Contributions are made with after-tax dollars, meaning withdrawals made during retirement are generally tax-free, provided certain conditions are met. The investments also grow tax-free.
SEP IRA: Simplified Employee Pension (SEP) IRAs are employer-funded retirement accounts primarily used by small businesses and self-employed individuals.
SIMPLE IRA: Savings Incentive Match Plan for Employees (SIMPLE) IRAs are similar to SEP IRAs but allow both employers and employees to contribute. They are typically used by small businesses with fewer than 100 employees.

Each type of IRA follows different rules regarding contributions, distributions, and taxation, which also impact the inherited IRA.

Rules for Inherited IRAs

Designated Beneficiary

The rules for inherited IRAs largely depend on the relationship between the original account holder and the beneficiary:

Spousal Beneficiary: A spouse has more flexibility with an inherited IRA. The spouse can treat the IRA as their own, roll it over into their own IRA, or remain the beneficiary and follow distribution rules.
Non-Spousal Beneficiary: Non-spouse beneficiaries have more limited options. They may not roll over the inherited IRA into their own IRA but must open an inherited IRA under their name.

Distribution Options

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 introduced new distribution requirements for inherited IRAs.

Spousal Beneficiaries:
- Treat as Own: The spouse can treat the inherited IRA as their own, which means they can delay Required Minimum Distributions (RMDs) until they reach the age of 72 (for Traditional IRAs), while Roth IRAs do not require RMDs during the original owner’s lifetime.
- Remain the Beneficiary: The spouse can choose to remain the beneficiary of the inherited IRA and start taking distributions based on their own life expectancy or the deceased spouse’s age.
Non-Spousal Beneficiaries:
- 10-Year Rule: According to the SECURE Act, most non-spousal beneficiaries are required to withdraw the entire balance of the inherited IRA within ten years of the original account holder’s death. These distributions may be spread out over the 10-year period or taken all at once before the deadline.
- Life Expectancy (Stretch IRA) – Certain Eligible Designated Beneficiaries: Some specific groups, such as minor children, disabled or chronically ill beneficiaries, and individuals not more than 10 years younger than the deceased, may use the “stretch IRA” method to take distributions based on their expected lifespan.

Required Minimum Distributions (RMDs)

Beneficiaries of Traditional IRAs must typically start taking RMDs if the deceased account holder was over the age of 72 at the time of death. The schedules and amounts depend on whether the beneficiary is a spouse or non-spouse and other specific conditions outlined by the IRS.

Tax Implications of Inherited IRAs

When a beneficiary takes distributions from an inherited IRA, the tax treatment of these distributions depends on the type of IRA:

Traditional IRA: Distributions are generally taxed as ordinary income.
Roth IRA: Distributions are usually tax-free, provided that the Roth IRA was held for at least five years by the original owner.

Estate Taxes

Inherited IRAs are subject to federal estate taxes if the total estate value exceeds the exemption limit, which changes periodically. However, the value of the inherited IRA must be included in the overall estate valuation.

Managing an Inherited IRA

Beneficiaries of inherited IRAs must manage these accounts carefully to maximize their benefits and comply with tax laws:

Stay Informed About Distribution Requirements: Understanding the specific requirements for RMDs and distribution deadlines is crucial to avoid penalties.
Consider Tax Implications: Planning distributions to minimize tax impact is essential. For example, spreading distributions over several years might lead to lower overall tax liabilities.
Investment Strategy: Maintaining a suitable investment strategy within the inherited IRA can continue to grow the assets while minimizing risks.
Seek Professional Advice: Beneficiaries should consider consulting financial advisors or tax professionals to navigate inherited IRA rules and optimize their financial outcomes.

Pros and Cons of Inherited IRAs

Pros

Continued Tax Deferral: Beneficiaries can benefit from continued tax-deferred growth within the inherited IRA.
Flexible Distribution Options for Spouses: Spouses have multiple options for managing and distributing inherited IRA funds.
Potential Tax-Free Withdrawals (Roth IRAs): Inherited Roth IRAs may provide tax-free withdrawals, which can be highly advantageous for long-term financial planning.

Cons

Mandatory Withdrawals: Beneficiaries must take distributions according to specific schedules, which can interfere with their financial planning.
Tax Liabilities: Distributions from Traditional IRAs are subject to ordinary income tax, potentially increasing the beneficiary’s taxable income.
Complex Rules: Navigating the complex rules and regulations surrounding inherited IRAs can be challenging and may require professional assistance.

Conclusion

Inherited IRAs are valuable financial assets that allow beneficiaries to continue benefiting from the tax-deferred or tax-free growth of the deceased’s retirement savings. However, managing these accounts requires careful planning and adherence to specific IRS rules regarding distributions and taxes. Understanding the different types of IRAs, the new regulations introduced by the SECURE Act, and the tax implications of inherited IRAs is essential for beneficiaries to make informed financial decisions. Additionally, seeking guidance from financial professionals can help beneficiaries optimize the benefits of inherited IRAs while complying with all regulatory requirements.