The loss of a loved one can lead to emotional burden and significant financial debt related to the settling of the estate. If you are the beneficiary of a retirement plan's assets, you can inherit control of all or part of the retirement account. So what can you do with an inherited IRA or a Roth IRA? What responsibilities do you have to the new inherited account? The solutions to these problems may depend on your relationship with the deceased. Here, we will talk about several factors to consider when dealing with an inherited IRA.
Understanding how Inherited IRA, RMD, and RBDs work
Some terms to be aware of include the required minimum distribution and the required beginning date. The required minimum distributions (or "RMD") are withdrawals that the IRS requires you to withdraw from tax-deferred accounts (such as IRAs). They are calculated annually using the value of an account as of December 31 of the preceding year and a "life expectancy factor" based on the IRS life expectancy tables.
The required beginning date (RBD) is when a person must start making these mandatory minimum distributions. This date is usually April 1, after the calendar year in which the account holder turns 72. For example, if the account holder is 72 on February 28, 2021, they must start RMDs by April 1, 2021. It is essential to note that the RBD may be different for inherited accounts, which may depend on the rollover strategy, and the deceased's age.
As the primary beneficiary, a spouse has several options for an inherited IRA.
If you are the chief beneficiary of your spouse's retirement savings, you can usually think of the inheritance as your own. The spouse has several options to consider when deciding what to do with an inherited retirement account.
Option 1: withdraw the inherited IRA assets as a fixed amount
Perhaps the simplest option, a spouse who inherits the retirement savings can choose to withdraw the entire amount at one time. Depending on the type of retirement account type, the withdrawal may be subject to income tax. If the amount withdrawn is large enough, that lump sum may even put you in a higher tax category, forcing you to pay higher taxes per transaction. If the IRA is a Roth IRA, a withdrawal of the full amount will be tax-exempt, as long as the mandatory five-year retention period (known as the "5-year rule") has already been met. This rule states that 5-tax-years must pass after the initial contribution to a Roth IRA before the first distribution can be made without penalty. Make sure your spouse follows the five-year rule to avoid unexpected taxes on Roth IRA withdrawals.
Option 2: Transfer Inherited IRA Assets Straight to Your Traditional or Roth IRA
Perhaps the easiest option is to transfer the assets from your spouse's account to your traditional or Roth IRA account. When you transfer assets to your IRA account, the distribution rules are the same as if the assets were primarily you. Therefore, if you transfer assets to a traditional IRA on your behalf, you will need to get your first RMD by April 1, after the calendar year in which you turned 72. If you are transferring assets to a Roth IRA, you won't be subject to RMDs.
The downside to this option is that you are not at least 59½ years old and intend to withdraw money from the IRA in the near future. As with the usual rules for traditional IRAs, any termination before the age of 59½ is subject to a 10% penalty. Therefore, if you need to withdraw money from your account, it may be best to transfer the assets to an inherited IRA.
Please note that if your spouse has a Traditional IRA (or pre-tax account), you have the option of transferring it to a Roth IRA on your behalf; however, the full amount will be added to the gross income for the year, and you will need to pay regular income tax on this amount. You can choose to do this if the benefits (tax-free income later and never RMD) outweigh the costs (paying full tax today).
Option 3: transfer resources to an inherited IRA
In addition to transferring the inherited IRA assets directly to your personal IRA, you can also generate a new "inherited IRA" account in your name before the age of 59½. If you go with this option, the RMD will depend on whether your spouse has already achieved the RBD or not. For example, if your spouse died at age 75 and you chose to transfer your assets to a traditional IRA, you should start receiving distributions from the account by December 31 of the year following the death of your spouse. These distributions will be calculated using the life expectancy factor.
Alternatively, if your spouse died before age 72, you may have the option to defer RMDs until age 72. These distributions will be calculated using the spouse's life expectancy factor, which expires on December 31 of each year. There is also the "5-year method" or "5-year rule", according to which the spouse intends to pay the entire bill before December 31 of the fifth year following the death of the owner.
Non-Spouse Beneficiaries Rules of Inherited IRA Accounts
A beneficiary other than the deceased's spouse, that is to say, brothers and sisters, children, close friends, cannot treat the account as if it were their own. This beneficiary can open an inherited IRA and be subject to RMD or withdraw assets as a lump sum.
Two methods of transferring inherited assets: Inherited Roth IRA or Inherited IRA
If the inherited IRA is a Roth IRA and you are a different beneficiary than your spouse, you will be subject to RMD. They must begin no later than December 31 of the year following the death of the initial account holder. Distributions inherited from Roth IRAs are not taxable, but traditional inherited IRAs are. Starting in the year 2020 under the SECURE Act, these accounts must be fully distributed by the end of the 10th year following the account holder's death, which could pose tax problems for traditional IRAs.
Distribution of lump sum for unmarried beneficiaries
Distributing the full amount is always an option for unmarried beneficiaries, regardless of Roth vs. Traditional or the age of the deceased. Roth IRAs that have complied with the five-year rule will have tax-free distributions, while traditional IRAs will be subject to normal tax rates.
It is best to seek the advice of a financial advisor to protect yourself from unforeseen tax burdens for all of the options described above.
Multiple heirs of inherited IRA assets must act independently
When an IRA contains multiple beneficiaries, each of them is treated as if their relationship with the original owner was not marital. Each beneficiary must transfer their share of the assets to a new inherited IRA and spread the entire account over ten years.
Inherited IRAs present opportunities for financial gain for beneficiaries.
Each of the many options available to those who inherit a retirement account with considerable assets has its caveats. Pay rapt attention to the tax implications of each option as it is an important issue for account beneficiaries. To avoid paying more taxes than you need to, consider all of your options with a trusted accountant or financial advisor who understands the nuances of these financial legacies.
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Karen Munoz, EA