Have you recently received an inheritance IRA but you aren’t sure what to do with it? Inheriting an IRA can be a generous gift but often people aren’t clear about the rules associated with it. Withdrawal rules and taxes will depend on your relationship to the original account owner and whether the account is a Roth IRA, Traditional IRA, SEP IRA, or SIMPLE IRA. It’s important that you understand all of the rules for an inherited IRA so that you don’t receive a significant penalty from the IRS.
What is an inherited IRA?
An Inherited IRA is an account opened for someone who inherits a retirement account when the original account owner passes away. Any person, estate or trust, can inherit an IRA. Spouses have the most options when it comes to inheriting an IRA.
How does an inherited IRA work?
Any type of IRA account that is inherited can be transferred to an Inherited IRA. This includes Roth IRAs, traditional IRAs, SEP IRAs, and SIMPLE IRAs. The income tax treatment remains the same from the original IRA to the inherited IRA. This means that if it was a traditional IRA (pre-tax dollars) then it will still be treated the same in an inherited IRA.
The first step you need to take if you inherit an IRA is to figure out what type of IRA account you inherited and what type of beneficiary you are. These two things are key to determine which inheritance IRA strategy may be best for you.
What are the new 2023 inheritance IRA rules?
On October 7th, 2022, the IRS announced that the new regulations will apply (at earliest) to the 2023 distribution year. The new rules state that individuals who inherit an IRA will need to take required minimum distributions during the 10-year period and withdraw all funds by the end of 10 years. This means that you can no longer let the money sit for 10 years and take out money as a lump sum at the end.
The old stretch IRA rules will apply to withdrawals during the years one through nine. You can use an Inherited IRA calculator to find out what your required minimum distributions may be depending on your age. If you are affected by the new rules, and failed to take RMDs in 2021 and 2022, you will not be penalized.
Inherited IRAs come with more complications nowadays than what they previously did. The size of the RMDs will depend on the IRA balance and the age of the beneficiary. This could mean that those who do inherit traditional IRAs could end up paying more taxes as the withdrawals may push them into a higher tax bracket.
(Don’t forget to download the ‘What Issues Should I Consider If I Experience A Sudden Wealth Event?‘ guide if you haven’t already.)
Inherited IRA from spouse options
If you inherit an IRA from your spouse (the account owner) and they were less than 72 years old, then you have several options.
1. Spousal Transfer (treat it as your own): If you are a surviving spouse, then you can roll the inherited IRA into your own existing or new IRA. This is called a spousal transfer and it is only allowed if you are a surviving spouse. Even if the deceased person was over 72 and was taking RMDs from a traditional IRA, once you transfer the money to your account you can delay the RMDs until you turn 72. Roth IRAs don’t require RMDs so you don’t need to worry about withdrawals if you inherit a Roth IRA. This is a great option if you don’t need the funds straight away. However, be aware that if you do decide to withdraw the funds from your new IRA before you reach 59 ½ then you will be subject to the 10% early-withdrawal penalty.
2. Open an inherited IRA: If you are a surviving spouse, then you can transfer the assets into an inherited IRA. The original account owner’s financial institution will require you to open an inherited IRA account with them. Afterward, you can request a direct IRA-to-IRA transfer where you can move the funds to a new bank if you want to change banks. You can then withdraw the funds in two ways:
– Life expectancy method: where you take annual distributions based on your own life expectancy. This type of IRA is called a stretch IRA.
– 10-year method: this is where you withdraw all of the funds within 10 years.
3. Lump sum distribution: This is when all of the assets from the IRA are distributed to you. If it is a Roth IRA and the account is older than 5 years then you are not required to pay any taxes. If it is a Traditional IRA, then you will pay taxes on the distribution all at once but you will not incur a 10% early withdrawal penalty. Please be aware that this may push you into a higher tax bracket for that year.
What options do I have if I am a spouse and over 72?
If you inherit an IRA and you are over 72, then you have all of the above options available to you except for the 10 year method.
Inheritance IRA rules for non-spouse beneficiaries
If you are a non-spouse, or if you are the spouse but you’re not the sole beneficiary, then you need to be aware of the SECURE act. Previously, you could choose to take distributions over your lifetime which is called a stretch IRA. However, the SECURE Act of 2019 eliminated the stretch IRA for non-spousal beneficiaries who inherit the account on or after January 1, 2020.
The proposed IRS rule now states that RMDs are required during years one to nine and the funds from the inherited IRA must be liquidated by December 31 of the 10th year following the IRA account owner’s death.
What are some exceptions to the Inherited IRA 10 year rule?
Exceptions to the inherited IRA 10 year rule include if you are a spouse, a minor, are disabled or chronically ill, or those who are within 10 years of age of the original account owner.
What is the 5 year rule for inherited IRAs?
There are two 5 year rules that you need to be aware of:
1. No beneficiary named: If there is no beneficiary named then the estate will need to withdraw all of the money from the IRA within 5 years.
2. Roth IRAs: Roth IRA beneficiaries can withdraw contributions at any time tax-free. However, earnings from an inherited Roth IRA can also be withdrawn tax-free as long as the account had been opened for 5 years before the account owner died. The five year rule is important because if the account is less than 5 years old then you will owe taxes on the earnings that you withdraw. Once the account reaches the five-year mark from when the original owner opened it, earnings can be withdrawn tax-free.
Are inherited IRAs taxable?
An inherited IRA may be taxable depending on the type of IRA. If you inherit a Roth IRA, then you won’t have to pay any taxes as long as the original account owner opened the account at least 5 years ago. However, if you inherit a traditional IRA, SEP IRA or a SIMPLE IRA, then any amount that you withdraw will be subject to income taxes.
How can I minimize taxes on an inherited IRA?
The timing of the distributions can determine how much tax is owed on withdrawals from the account. Sometimes, you can minimize your taxes by taking distributions over the 10 year period so that you can avoid a large tax bill in a single year and potentially be bumped into a larger tax bracket. Another option is to withdraw the funds during a low earning year. If you are retiring in less than 10 years then you may want to wait until you retire to take the majority of your distributions to reduce the tax burden.
What happens if I don’t take RMDs from an inherited IRA?
If you don’t take the RMDs from the inherited IRA, then you will be subject to a penalty equal to 50% of the amount that should have been withdrawn. For example, if the minimum annual distribution is $30,000 and you don’t take it, the IRS penalty will be $15,000.
Can I roll an inherited IRA into my own IRA?
Yes, you can roll an inherited IRA into your own inherited IRA. The easiest way to do that is through a direct, trustee-to-trustee transfer from one account to the other.
Can an inherited IRA be split between siblings?
Yes, an inherited IRA can be split between beneficiaries. However, this must be done within the first year of the original account owner’s death.
What is the difference between an inherited IRA and a beneficiary IRA?
The terms ‘inherited IRA’ and ‘beneficiary IRA’ are used interchangeably. It really just depends on how it’s set up at the start. They essentially refer to the same thing as they are both IRAs that are inherited by a beneficiary after death.
What should I do if I inherit an IRA?
Inheriting an IRA usually happens during one of the most painful times of your life, when a loved one passes away. It’s important to understand all of the rules associated with an inheritance IRA so that you can plan an effective inheritance IRA strategy. It’s often best to consult with a fiduciary financial advisor to make sure that you know all of your options and which one will best suit you. Book a complimentary discovery call today to see how we can help you!
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.
