If you are currently saving for your retirement, then you are probably aware of IRAs (Individual Retirement Accounts).
But we get it; thinking about money and retirement might make you a little uncomfortable. Even more, making choices for your retirement accounts can be overwhelming with all of the different options and financial jargon. 🙈
The thing is though, some costly decisions can be made when inheriting an IRA, so we will discuss some must-knows about inherited IRAs and how to avoid some of those unnecessary expenses.
Before we get into the must-knows, let’s hit some of the basics first...
What is an inherited IRA?
An inherited individual retirement account is an IRA that is opened when you inherit a tax-advantaged IRA or 401(k) account after the death of the account’s owner.
Typically, the heir, or the ‘beneficiary,’ must move the funds of the original owner’s account and transfer them into a new account in the heir’s name; this is why you may also hear inherited IRAs referred to as, beneficiary IRAs.
All types of IRAs can be turned into an inherited IRA (e.g. Traditional IRA, Roth IRA, SEP IRA, Simple IRA) and will transfer the tax treatment of the original account to the new IRA. (If the original account were a traditional IRA, it would remain as a pre-tax IRA, and if it were a Roth IRA, it would continue to be treated as a post-tax IRA.)
Here is the #1 thing you need to remember about inherited IRAs:
Do not cash out the IRA and put it into your account before researching or getting advice from a financial planner or tax professional.
Once you’ve cashed it out, there is no going back.
It is crucial to understand the tax implications of the different choices before making a decision. There are a lot of rules surrounding inherited IRAs, and a lot of changes in the last few years so working with a professional can save you major headaches down the road.
The SECURE Act of 2019:
Tax laws regarding inherited IRAs have always been complicated, and the Setting Every Community Up For Retirement Enhancement (SECURE) Act of 2019 made substantial changes to the regulations.
These new regulations did not change much for spousal inherited IRAs. The changes were focused mainly on non-spousal heirs. Before getting into the changes to non-spousal rules, here is some must-know info for spousal inherited IRAs that were inherited in 2020 or after.
Rules for IRAs Inherited Before December 2019
Before 2020, the rules for both spousal and non-spousal inherited IRAs had essentially the same rules. Inherited IRAs that were inherited in or before December 2019 are grandfathered from the regulations of the SECURE Act of 2019, and these pre-2020 inherited IRAs can still follow the old Inherited IRA rules, which are:
- Beneficiaries can choose to take distributions over their own life expectancy, known as the “stretch option.” The stretch option leaves the funds in the IRA for as long as possible.
- OR: the beneficiary must deplete the inherited account within five years of the original owner’s death.
The benefit of the stretch option is that it gives the beneficiary the ability to shelter funds from taxation while they could potentially grow over decades.
According to the five-year rule, if the stretch option is not taken, then the beneficiary per option two is forced to take money out of the account over time. If the account is substantial, this can add up to a large income tax bill for the beneficiary; Unless it is an inherited Roth IRA because taxes were already taken out before they were initially deposited.
Rules for IRAs Inherited After 2019
Rules for IRAs changed in 2020, and accounts inherited after December 2019 must follow the new regulations of the SECURE Act of 2019.
Spousal Inherited IRAs
When inheriting an IRA from a spouse, the surviving spouse can:
- Treat the IRA as if it were their own and naming themselves as the owner.
- Treat the IRA as if it were their own by rolling the inherited IRA into another account, such as an IRA, 403(b), and qualified employer plans.
- Treat themselves as the beneficiary of the plan.
Suppose the beneficiary is a spouse of the original IRA owner, chronically ill or disabled, a minor (son or daughter), or not less than ten years younger than the original account owner. In that case, the beneficiaries still have the same two options of the stretch option or depleting the account within five years.
The most significant change for spousal inherited IRA beneficiaries is that they no longer need to take required monthly distributions (RMDs) until age 72, which was increased from 70 ½ the SECURE Act of 2019.
Spouses can set up a separate inherited IRA account, and have 60 days from receiving a distribution to roll it over into their own IRA, as long as it’s not an RMD. The age of the deceased IRA account owner will determine how the IRA is treated because if the original owner had already started taking their RMDs before their death, the spouse must continue to take the RMDs as previously calculated or they can create a new schedule for RMDs based on their own life expectancy.
If the deceased owner had not yet started to take RMDs, the spousal beneficiary will have a five-year window to withdraw the funds from the original account. This withdrawal would then become subject to income taxes.
Non-Spousal Inherited IRAs
Prior to The SECURE Act of 2019, non-spousal inheritors could handle the RMDs essentially the same way as spousal heirs. Non-spouse beneficiaries also used to be allowed to recalculate RMDs based on their life expectancy like spouses; this would often significantly decrease the annual RMDs that had to be taken, and the amount of taxes due on them with traditional IRAs.
The SECURE Act of 2019 eliminated the stretch IRA option for non-spouse beneficiaries. Instead of being required to take a minimum distribution based on life expectancy tables, accounts now need to be depleted by the end of aten-year period.
The SECURE Act of 2019 also mandates that non-spouse beneficiaries cannot treat an IRA as their own, or transfer them into an existing IRA in their name. Additionally, non-spouse beneficiaries cannot leave assets in the IRA either.
Non-spouse beneficiaries can:
- Set up a new inherited IRA account, OR
- Immediately take a lump-sum distribution payment
- Skip RMDs and deplete the account within 10 years
Non-spouse beneficiaries cannot:
- Use the stretch option
- Be required to take annual RMDs
- Treat an inherited IRA as their own
- Transfer an inherited IRA into an existing IRA in their name
- Leave assets in the inherited IRA longer than 10 years
- Do not cash out an inherited IRA until you know and understand what you are going to do with those funds and the tax implications that will follow.
- You can’t make new contributions to an inherited IRA.
- You can transfer the funds from an inherited IRA into a new or existing IRA account if you are a spouse.
- Spousal beneficiaries now do not need to begin taking RMDs until age 72.
- Non-spouses no longer need to take annual RMDs.
- Non-spouses must now deplete all of the funds in an inherited IRA by the end of year 10, or take an immediate lump-sum distribution.
Do you have questions? Schedule a meeting; I am here to help!