What Is an Inherited IRA?
Let me explain what an inherited IRA is. It's an account you open when you inherit an IRA or an employer-sponsored retirement plan after the original owner passes away. As the beneficiary, you could be a spouse, relative, unrelated person, or even an entity like an estate or trust. The rules differ based on whether you're a spouse or not, so pay attention to how inherited IRAs function.
Key Takeaways
An inherited IRA, sometimes called a beneficiary IRA, is what you set up when you inherit an IRA after the original owner dies. You can't add any more contributions to it. The rules for withdrawals depend on if you're a spouse or a non-spouse. Thanks to the SECURE Act, non-spousal beneficiaries have to pull out all the funds within 10 years. And for traditional IRAs, owners must start required minimum distributions at age 73.
How an Inherited IRA Works
You might hear an inherited IRA referred to as a beneficiary IRA. Many top brokers offer help with inheriting IRA assets, sorting out taxes, and keeping the retirement account status intact. The tax laws for these are complex, and they got even more so with the SECURE Act of 2019, which changed things mainly for non-spousal heirs.
You can open an inherited IRA from proceeds of any IRA type, like traditional, Roth, rollover, SEP, or SIMPLE. Usually, you have to transfer the assets from the deceased's IRA into a new inherited IRA in your name. Do this even if you're planning a lump-sum distribution. Remember, you can't make additional contributions to it.
The IRS has guidelines for beneficiaries of inherited IRAs. You'll need forms like 1099-R and 5498 for reporting distributions and the IRA itself for taxes. Inherited IRAs are handled the same whether traditional or Roth, but the tax on withdrawals matches the IRA type—pre-tax for traditional, post-tax for Roth.
Inherited IRAs: Rules for Spouses
If you're a spouse, you have more options with an inherited IRA. You can roll it over, or part of it, into your own existing IRA. This lets you defer required minimum distributions until you're 73.
RMDs used to start at 70½, but the SECURE Act raised it to 72, and SECURE 2.0 bumped it to 73. You have 60 days from getting a distribution to roll it into your IRA, as long as it's not an RMD.
You could also set up a separate inherited IRA. How you handle it depends on the deceased's age. If they were already taking RMDs, you continue based on that or recalculate using your life expectancy. If not, and they hadn't reached their required beginning date, you have five years to withdraw the funds, which then face income taxes.
Inherited IRAs: Rules for Non-Spouses
If you're not a spouse, you can't treat the inherited IRA as your own. No additional contributions, and you can't transfer it to your existing IRA. You must set up a new inherited IRA unless you take a lump-sum payout right away.
The SECURE Act hits non-spouse beneficiaries hard on distributions. Before, you could recalculate RMDs based on your life expectancy, reducing annual withdrawals and taxes for traditional IRAs. If you inherit a Roth, you must take distributions, but they're tax-free and penalty-free even if you're under 59½.
Now, for inheritances after Dec. 31, 2019, you typically must empty the account within 10 years of the death. Exceptions include those within 10 years of the deceased's age, disabled or chronically ill people, or minor children who are direct descendants— but once minors reach adulthood, the 10-year rule kicks in. For those exceptions or pre-2020 inheritances, old rules apply with no strict timetable; withdraw gradually or all at once.
Your Options for Receiving Benefits
As a beneficiary, you have options to claim your inheritance, but they depend on your relationship to the deceased. Everyone can take a lump sum or disclaim it. Natural beneficiaries might leave proceeds in the plan, with spouses having the most choices, then non-spousal natural persons, and non-natural like charities having the least.
Options for Spousal Beneficiaries
- Take a lump-sum distribution, which is taxable unlike life insurance proceeds.
- Roll over into your own like-kind IRA, with RMDs based on your age using the IRS Uniform Lifetime Table.
- Transfer to an inherited IRA, with RMDs based on the decedent's age using the Single Life Expectancy Table.
- Disclaim the proceeds, passing them to other beneficiaries or the estate.
Options for Non-Spousal Beneficiaries
- Take a lump-sum distribution, which is taxable.
- Disclaim the proceeds, transferring to others or the estate.
- Transfer to your own inherited IRA; for deaths before 2020, RMDs use your life expectancy; for after, payout within 10 years unless exempted.
Frequently Asked Questions (FAQs)
Do you pay taxes on inherited IRAs? It depends. Roth inheritances are usually tax-free, but traditional ones tax withdrawals. Estates might deduct estate taxes paid on the IRA.
What if you inherit from a parent? If the child is a minor, a custodian manages until adulthood, then full access, with possible taxes on withdrawals.
How to avoid taxes? Best strategies happen before death, like converting to Roth. As inheritor, avoid non-qualifying distributions.
The Bottom Line
People use traditional and Roth IRAs for retirement planning, but if they die early, heirs deal with inherited accounts. Roths offer better tax avoidance, while traditional ones have stricter RMDs and constraints.
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