Things You Should Know About Inherited IRA’s – January 2021

Part of your overall financial planning may include things like college funds for children and retirement funds for your later years. Your financial advisor may have recommended IRAs (Individual Retirement Accounts) as one of your assets to grow funds for future use. As with all your assets, beneficiaries should be named for each one. There are several considerations when choosing your beneficiaries, particularly as it relates to the rules and tax liabilities when they inherit your IRA account(s). 

IRA basics 

First, let’s cover some basic facts about the type of IRA account you may have. There are two main IRA accounts for individuals – a traditional IRA and a Roth IRA. A traditional IRA offers a tax deduction on your income when contributions are made to the account, which can help offset your tax liabilities. Taxes are due when the money is withdrawn from the IRA later. If money is withdrawn before age 59½, the IRS (Internal Revenue Service) adds a 10% tax penalty on top of the owner’s income tax rate at the time the withdrawal or distribution is done. 

Otherwise, traditional IRA owners must take a required minimum distribution (RMD) beginning at age 72 (or 70½ if you reach 70½ before January 1, 2020). All RMD withdrawals will be included in your taxable income. Be aware that IRA owners face a 50% penalty on the dollar amount of the RMD for that year if they fail to take the distribution. 

A Roth IRA, on the other hand, offers tax-free withdrawals in retirement since the money is taxed at the time contributions are made into the account. There are no required distributions from a Roth IRA. 

Inherited IRA Tax Considerations

Now that you understand the basic differences between a traditional and Roth IRA, it is time to consider the laws and tax implications as they relate to your beneficiaries. Typically, a spouse or children are designated as beneficiaries and there are different rules for each of them. These can be quite complicated and professional services should be used to ensure the money and accounts are handled properly. 

If you are the named beneficiary of an individual retirement account (IRA), it is important to know it may not be considered a tax-free inheritance. Tax laws are subject to change, but the current tax laws (applicable to 2020 tax filings) state that while receiving the account inheritance is tax-free, the required minimum distributions from the account may be taxable. 

As mentioned above, a traditional IRA’s distributions are taxed at the beneficiary’s income tax rate while a Roth IRA’s distributions are not. If you inherit a Roth IRA, it is tax-free if the IRA was held for at least five years prior to the owner’s death (starting January 1 of the year in which the first Roth IRA contribution was made). Withdrawals from a Roth IRA remove those funds from further tax-sheltered growth in the Roth account.

Another factor is the relationship of the beneficiary to the deceased. When the beneficiary is the spouse of the deceased owner, the spouse has the option of taking the account and managing it as if it were their own, including the calculation of required minimum distributions (RMDs). 

Surviving Spouse Beneficiaries

Often, a spouse is the beneficiary of their deceased spouse’s IRA, and they will have more flexibility than other beneficiaries regarding when they must withdraw funds. The spouse has a few choices: 

  • They can name themselves as the current IRA account owner. 
  • They can roll it over or transfer it into their existing IRA. 
  • They can name themselves as the beneficiary rather than treating the IRA as their own.

Deciding on the right option is usually based on when the spouse is due to take their own IRA required minimum distributions and whether the deceased owner was taking their RMDs at the time of their death. A trusted financial and tax advisor can help the surviving spouse make the best decision based on the total amount of the RMDs from the inherited funds. These distributions can have significant income tax implications for the spousal beneficiary if the wrong decision is made. 

Another consideration is the spousal beneficiary’s age. If they are not more than 10 years younger than the original account holder, the spouse is entitled to lifetime distribution from the inherited IRA. (See section below on the SECURE Act regarding changes to IRA withdrawals in 2020.) 

RMDs are based on the life expectancy of the original IRA owner. For example, if the original owner dies before the year they turn 72 years old, distributions don’t need to begin until the year the original owner would have turned 72 years old.

Depending on the surviving spouse’s financial circumstances, it may be better to use the longer single life expectancy with the smaller annual RMDs amount to delay tax liabilities on the inherited IRA funds. The beneficiary can always withdraw additional funds if needed. 

Non-Spousal Beneficiaries

A non-spousal beneficiary may not roll the funds into their own IRA nor can they contribute funds to the IRA from an inherited IRA. The funds must be rolled into a special IRA. If the beneficiary inherited more than one IRA from the same person, they might be able to combine account balances of the same type. For example, two inherited traditional IRA accounts could be combined into one. It is important to consider consulting with a qualified financial advisor, such as a CERTIFIED FINANCIAL PLANNER™ professional, or tax advisor to make sure the inherited accounts are properly managed.

There is no required withholding when a beneficiary makes a withdrawal from the inherited IRA, but taxes will still be due to the IRS (Internal Revenue Service). Interest and penalties can accrue so be sure to get sound financial advice from an experienced advisor, such as a CFP® professional when you decide to make withdrawals from inherited IRAs. 

Your CFP® professional, or another financial advisor, should work with your tax advisor or accountant to plan for withdrawals and tax implications. For example, beneficiaries need to be aware that when the account does well, the required distribution amount may go up, which can impact their taxes. 

Important Note on the SECURE Act

The SECURE Act (Setting Every Community Up for Retirement Enhancement, 2019), passed by Congress, created a requirement that non-spousal beneficiaries must withdraw the entire balance of the IRA account within 10 years of the original account holder’s death. This rule only applies to IRAs whose original owners died after Dec. 31, 2019. Owners who died prior to that day are grandfathered in, allowing the previous “stretch rules” to apply to account withdrawals. There are certain exceptions to this 10-year rule, such as a beneficiary who is chronically ill or is a minor child. 

There are options for beneficiaries of an inherited IRA: 

  • Open an inherited IRA account
  • Take a distribution (which will be taxable)
  • Disclaim all or part of the inheritance, which will cause these funds to pass to other eligible beneficiaries. 

As a reminder, inherited IRA accounts cannot be transferred to or rolled over into the beneficiary’s other IRA accounts, and a beneficiary can name their own beneficiaries to the account.

Considerations When Choosing Your Beneficiaries

In the case where the original IRA account holder has children from a previous marriage, remarries, and names a later spouse as a beneficiary, the possibility arises that those children will lose their portion of their parent’s inheritance. This can occur if the surviving spouse rolls that IRA money into their own account and those children are not named as beneficiaries. IRA account holders should carefully consider naming beneficiaries when future circumstances may impact their biological children. 

Considerations When Taking Funds from IRA

If the beneficiary is 59 ½ years old, it may not make sense to roll an inherited IRA into their own IRA account. Keep in mind that required minimum distributions begin at age 72, so consider consulting your financial planner and tax advisor for sound recommendations. 

Taxes will be due if the beneficiary takes a lump sum distribution, sometimes referred to as the “Vegas option”, such as when money is taken to spend on a large expenditure. You may wish to consider setting aside the tax liability amount at the time the withdrawal is made to avoid later financial strain. 

It is also important that the account beneficiaries become aware of their changed options in order to ensure that they minimize the tax impact as much as possible. Working with a knowledgeable financial advisor is a good idea in these situations.

The Bottom Line

When considering naming the beneficiaries for your assets, your IRAs pose unique challenges and considerations that factor into your decisions. The tax laws and rules surrounding them are complex and subject to change. Mistakes by beneficiaries, custodians, and plan sponsors can also potentially be costly. It is essential you consult with a professional who understands these rules and can continue to advise you annually. 

We’re Here To Help You 

Call us to learn more, ask questions about your specific circumstances, and determine if we are the right fit for you. Our phone number is 813-556-7171. We can also be reached by email at Elijah.Heath@LPL.com.

Elijah Heath, CERTIFIED FINANCIAL PLANNER™ professional, is a fiduciary with an ethical obligation to provide information, products, and services in your best interest, not what earns him the best fee or commission. Heath Wealth Management wants to be your advisor for life so you, your children, and your grandchildren all benefit from the relationship.