Losing a loved one can bring not only an emotional burden, but also significant financial responsibilities related to settling the estate. If you are a beneficiary to retirement plan assets, you may inherit control of all or part of a retirement plan account. So, what exactly can one do with an inherited Individual Retirement Account (IRA) or a Roth IRA? What responsibilities do you have to the newly inherited account? The answers to these questions may depend on your relationship to the deceased. Here I will discuss several factors that will determine what you can do with inherited retirement assets.
Understanding Inherited IRAs, RMDs, and RBDs
Some terminology you should be familiar with includes Required Minimum Distribution and Required Beginning Date. Required Minimum Distributions (or “RMDs”) are withdrawals that the IRS requires you to take from tax-deferred accounts (such as IRAs). These are calculated each year using the value of an account on December 31st of the prior year and a “life expectancy factor,” which is based on IRS Life Expectancy tables.
The Required Beginning Date (RBD) is the date by which a person is required to start taking these Required Minimum Distributions. Typically, this date is April 1st following the calendar year in which the account owner reaches age 72. For example, if the account owner’s 72nd birthday is February 28th, 2017, they must begin RMDs by April 1st, 2018. It is important to note that the RBD may be different for inherited accounts, which may be dependent on the rollover strategy and the age of the deceased person.
As Primary Beneficiary, a Spouse Has Several Options for an Inherited IRA Account
If you are the primary beneficiary of your spouse’s retirement assets, you can generally treat inherited assets as if they are your own. A spouse has several options to consider in determining what do with an inherited retirement account.
Option 1: Withdraw Inherited IRA Assets as a Lump-Sum
Perhaps the most straight-forward option, a spouse who inherits retirement assets can choose to withdraw the entire sum of the account at once. Depending on the original retirement account type, the withdrawal may be subject to income taxes. If the sum withdrawn is large enough, this lump-sum may even move you into a higher tax bracket, which would subject you to paying higher income taxes on the transaction. If the IRA in question is a Roth IRA, a lump-sum withdrawal will be tax-free so long as the mandatory five-year holding period (known as the “5-year rule”) has already been met. This rule dictates that five tax years must pass after the first contribution to a Roth IRA before the first distribution can be made without penalty. Ensure your spouse has met the five-year rule to avoid unexpected taxation on Roth IRA withdrawals.
Option 2: Transfer Inherited IRA Assets Directly to Your Traditional or Roth IRA
Perhaps the easiest option is simply to transfer assets from your spouse’s account to your own Traditional or Roth IRA. When transferring assets to your own IRA, distribution rules are the same as if the assets had been yours in the first place. Therefore, if you roll the assets into a Traditional IRA in your name, you’ll have to take your first RMD by April 1st following the calendar year in which you turn age 72. If you roll the assets into a Roth IRA, you will never be subject to RMDs.
The disadvantage to this option comes if you are not at least age 59½ and you plan to draw money out of the IRA sometime in the near future. Just like regular Traditional IRA rules, any withdrawals before age 59½ are subject to a 10% penalty tax. So, if you’re needing to take money out of the account, it may be best to transfer the assets into an inherited IRA.
Note that if your spouse had a traditional IRA (or otherwise pre-tax account), you do have the option to roll this into a Roth IRA in your name. The entire amount, however, will be added to your gross income for the year and you’ll have to pay ordinary income taxes on that amount. One may choose to do this if the benefits (tax-free income later and never any RMDs) outweigh the costs (paying taxes on the entire amount today).
Option 3: Transfer Assets into an Inherited IRA
In addition to transferring inherited IRA assets directly into your personal IRA, you can also create a new “inherited IRA” account in your name. Though very similar to transferring to your own account, this method avoids the 10% penalty tax for withdrawals before age 59½. If you choose this option, the RMD will depend on whether or not your spouse had reached his or her RBD yet. For example, if your spouse passed away at age 75, and you choose to roll over his or her assets into a Traditional IRA, you must begin taking distributions from the account by December 31st of the year following your spouse’s death. These distributions will be calculated using your life expectancy factor.
Alternatively, if your spouse passed any time before age 72, you may have the option to defer RMDs until your spouse would have turned age 72. These distributions will be calculated using your spouse’s life expectancy factor, due December 31st each year. There is also what’s referred to as the “5-Year Method” or “5-Year Rule” in which the spouse plans to liquidate the entire account by December 31st of the fifth year after the year in which the account owner passed away.
Rules for Non-Spouse Beneficiaries of Inherited IRA Accounts
A beneficiary that is not the spouse of the deceased – i.e., siblings, children, close friends – may not treat the account as if it is their own. This type of beneficiary can either open an Inherited IRA and be subject to RMDs or withdraw the assets as a lump sum.
Two Methods for Transferring Inherited Assets: Inherited IRA or Inherited Roth IRA (New in 2020)
If the inherited IRA is a Roth IRA, and you are a non-spouse beneficiary, you become subject to RMDs. These must begin by December 31st of the year following the original account owner’s passing. Inherited Roth IRA distributions are not taxable, however, Inherited Traditional IRAs are taxable. Starting in 2020 under the SECURE Act, these accounts must be completely distributed by the end of the 10th year following the account owner’s death, which could potentially cause tax issues in the case of the Inherited Traditional IRA.
Lump-Sum Distribution for Non-Spouse Beneficiaries
The lump-sum distribution is always an option for non-spouse beneficiaries, regardless of Roth vs. Traditional or the age of the deceased. Roth IRA accounts that have met the five-year rule will enjoy tax-free distribution while Traditional IRAs will be subject to the normal income tax rates.
For all of the options outlined above, it is best to consult a financial advisor in order to protect yourself from unexpected tax burdens.
Multiple Beneficiaries of Inherited IRA Assets Must Act Independently
When a retirement account contains multiple beneficiaries, they are each treated as if their relationship to the original owner is non-spousal. Each beneficiary must transfer their portion of the assets into a new Inherited IRA and distribute the entire account within 10 years.
Inherited Retirement Accounts Present Opportunities for Financial Gain for Beneficiaries
The various options available to those who inherit a retirement account with considerable assets each contain their own caveats. Paying attention to the tax implications of each option is an important aspect for account beneficiaries. To protect yourself from paying more taxes than required, consider all of your options with a trusted financial advisor who is trained to understand the nuances of these financial inheritances.