Inheriting an IRA, whether a traditional or Roth account, comes with certain responsibilities. The rules for an inherited IRA depend on the specifics of your situation, as well as the deceased’s age and other circumstances. Unfortunately, you might have to make financial decisions about the account while dealing with your grief. Financial advisors work with beneficiaries to develop the best strategies. Let’s take a look at the government’s rules and the number of potential tax penalties or benefits that can apply to you and the IRA.
What Is an Inherited IRA?
An inherited IRA is an individual retirement account that gets opened for a beneficiary (this could be a spouse, family member, unrelated person, trust, estate or nonprofit organization) after the original owner dies. Tax rules for beneficiaries are different depending on whether you are a spouse or non-spouse.
IRAs are tax-advantaged accounts designed for retirement savings. They can hold stocks, mutual funds, bonds and a variety of other financial products. Your money earns interest and grows, tax-free. Until you reach retirement age, you don’t pay income tax or capital gains tax on the money in the account.
There are two major types of IRAs: traditional and Roth. With traditional IRAs, you contribute pre-tax earnings which are considered tax deductible. When you retire and start taking distributions from your IRA, those distributions will be taxed as income. For Roth IRAs, you contribute taxed income (and your contributions aren’t tax deductible) and when you retire, your withdrawals are tax-free.
As a beneficiary, you can transfer the money from any type of IRA to a new inherited IRA in your name. Note that the SECURE Act changed IRA rules in 2019, and now non-spouse beneficiaries must take money out of the account within 10 years of the owner’s death.
Rules for Inheriting a Traditional IRA: Spouses
The IRS lists three options for spouses who inherit a traditional IRA. If that’s you, the first option is to designate yourself as the account owner. You’ll put the account under your name (also known as “retitling”). This way, the account is yours to contribute to or withdraw from. Keep in mind, in most circumstances you have to be 59 1/2 or older to withdraw from an IRA without penalty.
Your second option is to roll the inherited account – tax-free – into an IRA you already possess. If you have an employer retirement plan, you can roll the inherited IRA into that account, as well. In both of these situations, you become the owner of the IRA.
The third option is to treat the account as a beneficiary, not as the owner. This could mean withdrawing the money in a lump sum, but that’s not your only choice. Treating the account as a beneficiary also means you have the option to transfer the assets to an “inherited IRA” held in your name. This will come with required minimum distributions (RMDs).
For the first two options, since you’re treating the assets as your own, you will have to pay a 10% penalty if you make an early withdrawal before you’re 59 1/2 years old. For the third option, you must start withdrawing funds from the account once you reach 72 years of age.
Note that the SECURE Act raised the RMD age from 70 1/2 to 72. However, if you were 70 1/2 by 2019, you still had to take your first RMD by April 1, 2020. The SECURE 2.0 Act, passed at the end of 2022, raised the RMD age to 73.
Rules for Inheriting a Roth IRA: Spouses
If you inherit a Roth IRA as a spouse, you can withdraw any or all of the account, tax-free, provided the account has existed for at least five years. In this case, you will not be charged the 10% early withdrawal penalty.
If you’d rather not take the Roth IRA as a lump sum, you have options. The better option for long-term savings is to transfer the assets to an existing Roth or to open a new Roth IRA. The account can grow without penalty, due to the lack of required minimum distributions. You can also leave the money in the account to grow indefinitely for the next generation. This is one of the biggest differences between Roth and traditional IRAs.
Rules for Inheriting an IRA: Children and Other Non-Spouse Beneficiaries
If a parent leaves you an IRA, you are the beneficiary. The IRS calls this situation a non-spouse inheritance. Parent to child is the most common non-spouse situation, but it’s not exclusive. As a non-spouse beneficiary, you cannot retitle the IRA in your own name. That benefit is only available for spouses. You can, however, transfer the account into a new account. This is known as an “inherited IRA.”
You could immediately cash out traditional or Roth IRAs through a lump sum distribution. With traditional IRAs, withdrawals are taxable income. However, withdrawals from Roth IRAs (as long as the account was open for at least five years) are tax-free. The downside of taking all the money out immediately is that you lose the long-term benefits that occur when the money grows within the IRA. However, it is an option if you need funds right away.
If you only want to withdraw some money, but not all, you can do so. You have to transfer the account to an “inherited IRA” held in your name. Note that non-spouse beneficiaries who inherit an IRA in 2020 or later now have to withdraw all funds within 10 years of the original owner’s death.
Before the 2019 SECURE Act, non-spouse beneficiaries could have used an estate planning strategy (called a “Stretch IRA“) to stretch distributions over their lifetime. So if you were a 35-year-old beneficiary in 2019, you could have stretched distributions over 48.5 years based on the IRS life expectancy tables.
While the SECURE Act eliminated this stretch option in favor of the 10-year payout provision for non-spouse beneficiaries, some beneficiaries could qualify for exceptions. These include minor children, people with disabilities, the chronically sick and others.
Bottom Line
Inheriting retirement accounts can be stressful. As it stands, the rules are complex and not the most user-friendly. You’ll want to make sure you understand all of your options before making any decisions about your inheritance. It’s always better to take your time with financial decisions.
Tips for Heirs
When you inherit an IRA, there are many rules to follow depending on your relationship to the account owner. A financial advisor can help you understand what you have to do, as well as answer any related questions you might have. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re a surviving family member of the decedent, you should learn about Social Security death benefits. You should also review what you might owe in taxes when a family member passes.
Do you want to figure out how much you will need to retire comfortably? SmartAsset’s retirement calculator can help you set up and plan your retirement goals.
Photo credit: ©iStock.com/monkeybusinessimages, ©iStock.com/fizkes, ©iStock.com/whyframestudio
The post Inheritance Rules for Traditional and Roth IRAs appeared first on SmartAsset Blog.
Source: https://finance.yahoo.com/news/inheritance-rules-traditional-roth-iras-153609854.html