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The distribution rules for inheriting an IRA are complicated, and the SECURE Act of 2019 introduced some significant changes. Consequently, the inherited IRA rules are different for certain beneficiaries if the account holder died in 2020 or later, compared to the rules before that time.
An inherited IRA is governed by IRS rules about how and when the money can be distributed, and whether the beneficiary is an eligible designated beneficiary or a designated beneficiary.
Other factors that influence inherited IRA distributions include the age of the original account holder when they died and whether the account holder had started taking required minimum distributions (RMDs) before their death. The SECURE 2.0 Act added some new changes to this factor.
Read on to learn about inherited IRA distribution rules, the changes to the rules, and how they might affect you.
Key Points
• The SECURE Act and SECURE 2.0 made some significant changes to inherited IRAs.
• Spouse beneficiaries have the option to take a lump-sum, roll over the IRA into their own account, open an inherited IRA, or disclaim the IRA.
• Many non-spouse beneficiaries must withdraw all funds from an inherited IRA within 10 years.
• Exceptions to the 10-year rule apply to spouses, minor children, disabled individuals, and those within 10 years of the original account holder’s age, who are all considered eligible designated beneficiaries.
• Strategies to manage RMDs and minimize taxes include spreading out withdrawals rather than taking a lump sum, following the latest inherited IRA rules, and possibly consulting a tax professional.
What Is an Inherited IRA?
When an IRA owner passes away, the funds in their account are bequeathed to their beneficiary (or beneficiaries), who then have several options to choose from when considering what to do with the funds. The original account could be a Roth IRA, traditional IRA, SEP IRA, or SIMPLE IRA.
If you inherit an IRA, the following factors determine what you can do with the funds:
• Your relationship to the deceased account holder (for example, whether you are a spouse or non-spouse)
• The original account holder’s age when they died
• Whether the account holder died before or after January 1, 2020
• Whether they had started taking their required minimum distributions (RMDs) before they died
• The type of IRA involved
Basic Rules About Withdrawals
There are a number of options available for taking inherited IRA distributions, depending on your relationship to the deceased. At minimum, most beneficiaries can either take the inherited funds as a lump sum, or they can follow the 10-year rule, which is one of the changes to the inherited IRA distribution rules that went into effect with the SECURE Act of 2019. (The previous rules allowed beneficiaries of inherited IRAs to stretch out withdrawals over their lifetime. Those rules are still in place if the original IRA account owner died before January 1, 2020.)
The 10-year rule regarding inherited IRAs means that the account must be emptied by the 10th year following the year of death of the original account holder.
The tax rules governing the type of IRA — Roth vs. traditional IRA — apply to the inherited IRA as well. So withdrawals from an inherited traditional IRA are taxed as income. Withdrawals from an inherited Roth IRA are generally tax-free (see more details about this below).
Exceptions for Eligible Designated Beneficiaries
Withdrawal rules for inherited IRAs are different for beneficiaries called “eligible designated beneficiaries” than they are for designated beneficiaries.
According to the IRS, an eligible designated beneficiary refers to:
• The spouse of the original account holder.
• A minor child under age 18.
• An individual who meets the IRS criteria for being disabled or chronically ill.
• A person who is no more than 10 years younger than the IRA owner.
If you qualify as an eligible designated beneficiary, and you are a non-spouse, here are the options that pertain to your situation:
• If you’re a minor child, you can extend withdrawals from the IRA until you turn 18.
• If you are disabled or chronically ill, or not more than 10 years younger than the deceased, you can extend withdrawals throughout your lifetime.
What Are the RMD Rules for Inherited IRAs?
Assuming the original account holder had not started taking RMDs, and you are the surviving spouse and sole beneficiary of the IRA, you have a few options:
• Roll over the funds to your own IRA. With this option, you do a rollover IRA into the same type of account (tax deferred IRA to tax deferred IRA, or Roth IRA to Roth IRA.) Once rolled over, the inherited funds become subject to regular IRA rules, based on your age. That means you have to wait to take distributions until you’re 59 ½ or potentially face a 10% penalty in the case of a tax-deferred account rollover like a traditional IRA.
RMDs from your own IRA are subject to your life expectancy (you can use the IRS Life Expectancy Table to determine what yours is) and they generally begin once you reach age 73.
• Move the funds to an inherited IRA. You can also set up an inherited IRA in order to receive the funds you’ve inherited. Again the accounts must match — so funds from a regular Roth IRA must be moved to an inherited Roth IRA.
Inherited IRAs follow slightly different rules. For example, you must take RMDs every year based on your own life expectancy. Distributions from a tax-deferred account are taxable, but the 10% penalty for early withdrawals before age 59 ½ doesn’t apply.
If the original account holder had started taking RMDs, the spouse has to take an RMD in the year in which they died. After that, the spouse switches to taking their own RMDs from there on out every year.
Some people prefer to open their inherited IRA account with the same firm that the deceased used. However, you can open an IRA with many financial institutions, including brokerages and some banks.
RMD Rules for Non-Spouses
If you are a non-spouse beneficiary, first determine whether you meet the criteria for an eligible designated beneficiary or a designated beneficiary.
• Eligible designated beneficiaries: This category includes chronically ill or disabled non-spouse beneficiaries; non-spouse beneficiaries not more than 10 years younger than the original deceased account holder; or a minor child of the account owner.
Most eligible designated beneficiaries can stretch withdrawals from the inherited IRA over their lifetime. However, once a minor child beneficiary reaches 18, they have 10 years to empty the account.
• Designated beneficiaries: These individuals must follow the 10-year rule and deplete the account by the 10th year following the year of death of the account holder. After that 10-year period, the IRS will impose a 25% penalty tax on any funds remaining.
In addition, because of changes introduced by the SECURE 2.0 Act, if the original account holder had begun RMDs, beneficiaries must continue to take RMDs yearly, based on their own life expectancy, while emptying the account within 10 years. However, if the account holder had not started taking RMDs, beneficiaries don’t need to make annual withdrawals, but they still must take all of the money out of the account within 10 years.
Multiple Beneficiaries
If there is more than one beneficiary of an inherited IRA, the IRA can be split into different accounts so that there is one for each person.
Then, generally speaking, you must each start taking RMDs based on the type of beneficiary you are, and all assets must be withdrawn from each account within 10 years (aside from the exceptions noted above).
Recommended: Retirement Planning Guide
Inherited IRA Examples
These are some of the different instances of inherited IRAs and how they may be handled.
Spouse inherits and becomes the owner of the IRA: When the surviving spouse is the sole beneficiary of the IRA, they can opt to become the owner of it by rolling over the funds into their own IRA. The rollover must be done within 60 days.
This could be an option if the original account holder had already started taking RMDs, because it delays the RMDs until the surviving spouse turns 73.
Non-spouse designated beneficiaries: An adult child or friend of the original IRA owner can open an inherited IRA account and transfer the inherited funds into it.
If the original account holder had begun RMDs, the beneficiary must take RMDs yearly, based on their own life expectancy, while emptying the account within 10 years. However, if the account holder had not started taking RMDs, the beneficiary does not need to make annual withdrawals, but they still must take all of the money out of the account within 10 years.
Both a spouse and a non-spouse inherit the IRA: In this instance of multiple beneficiaries, the original account can be split into two new accounts. That way, each person can proceed by following the RMD and distribution rules for their specific situation.
How Do I Avoid Taxes on an Inherited IRA?
Money from IRAs is generally taxed upon withdrawal, so your ordinary tax rate would apply to any tax-deferred IRA that was inherited, such as a traditional IRA, SEP IRA, or SIMPLE IRA.
However, if you have inherited the deceased’s Roth IRA, which allows for tax-free distributions, you should be able to make tax-free withdrawals of contributions and earnings, as long as the original account was set up at least five years ago, which is known as the five-year rule. As with an ordinary Roth account, you can withdraw contributions tax free at any time.
Common Mistakes to Avoid with Inherited IRAs
Because the rules for inherited IRAs are complex, it can be easy to make a mistake. Here are some common missteps to watch out for.
Taking a lump-sum distribution. If you withdraw the entire amount of the IRA at once, you may be pushed into a higher tax bracket and get hit by a significant tax bill. Spreading out the distributions may help you stay in lower tax brackets.
Mixing up the inherited IRA rules before 2020 and after 2020. The rules are complicated and confusing. You need to know what kind of beneficiary you are, what your options are for receiving the inherited IRA, and when you need to start and finish taking distributions. Otherwise, you could face a penalty — or potentially miss taking advantage of certain options you may have. IRS Publication 590-B spells out the rules. You might also want to consult with a trusted tax professional.
Neglecting to take RMDs. The rules regarding RMDs are different depending on the type of beneficiary you are, when the account holder passed away, and if that person had started taking RMDs. Make sure to follow the rules specific to your situation. Consider consulting a financial professional if you’re not sure.
Recent Changes and Updates to Inherited IRA Rules
The SECURE Act of 2019 introduced some changes that affect how inherited IRAs are handled. Designated non-spouse beneficiaries who inherited an IRA from an account holder who died in 2020 or later must empty the entire account within 10 years after the original owner’s death.
Furthermore, the SECURE 2.0 Act added some additional changes to the 10-year rule. If the original account holder had begun RMDs, beneficiaries must continue to take RMDs yearly, based on their own life expectancy, while emptying the account within 10 years. However, if the account holder had not started taking RMDs, beneficiaries don’t need to make annual withdrawals, but they still must take all of the money out of the account within 10 years.
Eligible designated beneficiaries, a category of beneficiary created by the SECURE Act of 2019, are generally not subject to these changes.
The Takeaway
Inheriting an IRA account has the potential to put individuals in a better financial position for their own retirement. But the rules regarding inherited IRAs are complex. Once you inherit an IRA, it’s wise to familiarize yourself with the inherited IRA rules and requirements that apply to your situation. You may also want to consult with a financial or tax professional.
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FAQ
Are RMDs required for inherited IRAs?
In many cases, RMDs are required for inherited IRAs. The specific rules depend on the type of beneficiary a person is, whether the account holder died before or after 2020, and if they started taking RMDs before their death.
Spouse beneficiaries can generally take RMDs based on their own life expectancy and stretch the withdrawals over their lifetime. Designated non-spouse beneficiaries of an account owned by someone who passed away in 2020 or later may or may not need to take annual RMDs, depending on whether the original account holder had started taking them. But either way, they typically have to completely empty the account within 10 years.
What are the disadvantages of an inherited IRA?
The disadvantages of an inherited IRA include knowing how to navigate and follow the complex rules regarding distributions and RMDs, and understanding the tax implications and potential penalties for your specific situation.
How do you calculate your required minimum distribution?
To help calculate your required minimum distribution, you can consult IRS Publication 590-B. There you can find information and tables that could help you determine what your specific RMD would be. It may also be helpful to consult a financial professional.
How should multiple beneficiaries handle an inherited IRA?
If an inherited IRA has multiple beneficiaries, one way to handle it is to split it into different accounts — one for each beneficiary. Then the individual beneficiaries can each decide what to do with the funds.
One thing to keep in mind, though, is that if the account holder died in 2020 or thereafter, all assets must be withdrawn from the accounts of non-spouse designated beneficiaries within 10 years.
What are the options for a spouse inheriting an IRA?
A spouse inheriting an IRA has several options, including taking a lump-sum distribution, rolling the funds over to their own IRA account, opening an inherited IRA, and disclaiming or rejecting the inherited IRA, in which case the next beneficiary would get it.
Spouse beneficiaries will likely want to consider the possible tax implications of each option and how RMDs will need to be handled if they roll the funds over into their own account or open an inherited IRA. It may be wise for them to consult a financial professional.
Can a trust be a beneficiary of an IRA?
Yes, a trust can be a beneficiary of an IRA. In this case, the trust inherits the IRA and the IRA is maintained as an asset of the trust and managed by a trustee. A trustee is required to follow the wishes of the deceased, which might be an option for an account holder with young children or dependents with special needs.
However, there are disadvantages to having a trust as the beneficiary of an IRA. For example, if the original account holder had not begun taking RMDs before their death or the account is a Roth IRA, trust beneficiaries must typically fully distribute all assets within five years to 10 years of the account owner’s death.
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