If you inherited an individual retirement account (IRA), that windfall may cost you money if you aren’t careful. That’s because there are rules around inherited IRAs to ensure the money in the account is eventually taxed and the IRS gets paid. Run afoul of any of them and you may create a costly tax event, plus you can be hit with fees and penalties.
What Is an Inherited IRA?
An inherited IRA, sometimes referred to as a beneficiary IRA, is created when an IRA is passed on to a spouse, family member or loved one when the account holder passes away. You can bequeath an IRA to anyone but there are different rules depending on the beneficiary.Assets in the original IRA must be transferred into an inherited IRA in the beneficiary’s name. Additional contributions cannot be made to the inherited IRA, but the funds remain tax deferred. If you are a non-spouse beneficiary you are required to liquidate the entire account by the 10th year of the account holder’s death. That’s where it gets tricky and potentially costly, given the distribution is treated as ordinary income.
Inherited IRA Rules
Thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, IRA accounts inherited by non-spouses after Dec. 31, 2019 are subject to the 10-year rule. There are some exemptions. If the beneficiary’s age is within 10 years of the deceased, is disabled or chronically ill or a minor child of the deceased, then the old rules apply. You can withdraw the money for as long as you want. If the deceased had already begun making required minimum distributions (RMDs), which kick in at age 73, the new IRA beneficiary must continue to do so during the 10-year period. Drawdowns are recalculated based on your life expectancy.You can leave an IRA to anyone but tax rules favor the spouse. “Spouses have the most flexibility when inheriting assets,” says Sham Ganglani, retirement distributions leader at Fidelity Investments. “They are the only ones that can treat the money as their own.”
Take Over the Account
You become the account holder of the IRA via a spousal transfer. The money is accessible immediately, but any gains are taxable until age 59 1/2. The account also has to meet the five-year holding period rule. That rule requires you to own the account for five years prior to withdrawals. RMDs are based on your age, not the age of the deceased account holder, and therefore can be spread out over a greater number of years if you are younger. This can help lower the potential tax hit.Open an Inherited IRA
You can roll the assets into an inherited IRA. RMDs are required based on your life expectancy and you have to empty the account by the tenth year. Withdrawals aren’t subject to the 10 percent early withdrawal penalties as long as the five-year rule is satisfied. This may be beneficial for spouses under the age of 59 1/2 who need access to the money.Take a Lump Sum
As long as you’ve owned the inherited IRA for five years you can take a lump sum distribution. The money will be treated as ordinary income but you won’t be subject to the 10 percent early withdrawal penalty if you are under the age of 59 1/2. The cash out could push you into a higher tax bracket, which means more income taxes due.Rules for Non-Spouses Inheriting an IRA
For non-spousal beneficiaries who don’t meet the exemptions, the rules are less flexible and options are limited to the following:Open an Inherited IRA
RMDs are based on your life expectancy, and the 10-year rule applies. You won’t incur the 10 percent early withdrawal penalty and assets continue to grow tax-deferred.Cash Out
You’ll pay taxes on a lump sum distribution but you aren’t subject to the 10 percent early withdrawal penalty if you’ve held the account for five years. This strategy could push you up into a higher tax bracket.Bottom Line
When it comes to handling inherited IRA requirements, financial advisors say spreading withdrawals out over several years is the best way to lower the tax implications. The beauty of an inherited IRA is, you can withdraw more if you need it one year, and less another year, without facing a penalty. “Try to avoid picking a lump sum,” says Ganglani. “That’s a tax consideration many people don’t think about.”Once you have the inherited IRA, don’t let loyalty keep you from making changes to the holdings within the account. They may have worked for your benefactor, but they may not be the best investment for your goals. “If those investments you inherited don’t align with your risk and your objectives for saving and growing assets, don’t be afraid to reallocate them,” Ganglani says. “Don’t think this is dad’s IRA.”
