Opening an inherited IRA account can be a daunting task, but understanding your options can make the process smoother.
You'll need to decide how to take distributions from the account, which can be either a lump sum or annual payments over a set period of time.
The required minimum distribution (RMD) rules apply to inherited IRAs, and you'll need to take annual distributions starting from the year after the account owner's death.
You have several options for how to take these distributions, including taking the entire balance in one year, or spreading it out over five years or the remainder of your life expectancy.
What You Need to Know
You'll want to know the rules for inheriting an IRA, and it's actually pretty straightforward. In most cases, beneficiaries can take distributions from an inherited IRA over their lifetime, rather than having to take the entire amount in one year.
You'll need to decide whether to take distributions over your lifetime or in a lump sum, and this decision will impact your taxes. The IRS requires beneficiaries to take required minimum distributions (RMDs) from an inherited IRA, starting in the year after the account owner passes away.
You can choose to take RMDs over your lifetime, or you can take the entire amount in a lump sum, but keep in mind that this will bump you up to a higher tax bracket. If you're under 72, you won't have to take RMDs, but you'll still need to report the inheritance on your tax return.
You'll also need to decide whether to open an inherited IRA or take the assets out of the account and into a new one. In some cases, it's more beneficial to leave the assets in the inherited IRA, while in others, it's better to take them out and put them in a new account.
If this caught your attention, see: Tax Accountant
Choosing When to Take Money
You'll need to take action to avoid running afoul of IRS rules if you've inherited an IRA.
You have two main options: transfer assets into an inherited IRA in your name and choose to take RMDs over your life expectancy or that of the deceased account holder's, or transfer assets into an inherited IRA in your name and choose to take distributions over 10 years.
The first option allows most of your funds to grow for potentially decades while you take minimal amounts out each year.
If the original owner of the IRA was under or at least age 72, you can choose between these two options. If you're not eligible, you can only select the 10-year rule.
Here are the key differences between the two options:
You'll need to consider the tax impact of withdrawals and the advantages of letting the money continue to grow over time when deciding which option to choose.
Choose When to Take Money
You have options when it comes to taking money from an inherited IRA. The rules depend on your age and relationship to the original owner.
If you're chronically ill or disabled, a minor child, or not more than 10 years younger than the original owner, you have two options. You can transfer assets into an inherited IRA in your name and choose to take RMDs over your life expectancy or that of the deceased account holder's.
If you're in this group, your ability to access these options depends on whether the original owner of the IRA was under or at least age 72. If the original owner was under 72, you can take minimal amounts out each year, allowing most of your funds to grow for potentially decades.
If you're a designated beneficiary, you can select only the 10-year rule. You'll have up until Dec. 31 of the year that is 10 years after the original account owner's death to fully withdraw the account.
Here are your options:
- Take RMDs over your life expectancy or that of the deceased account holder's
- Take distributions over 10 years and liquidate the account by Dec. 31 of the year that is 10 years after the original owner's death
Remember, if you're a designated beneficiary, you'll have to take all the money over 10 years, which can add up to a monstrous income tax bill unless the IRA is a Roth.
Take a Lump Sum
Taking a lump sum distribution can be a straightforward way to access the entire inherited amount, but be aware that it will no longer grow tax-deferred.
This means you'll have to pay taxes on the entire amount, which could push you into a higher income tax bracket.
You'll have to consider the tax implications carefully before making a decision, as it could have a significant impact on your finances.
The distribution will be subject to taxation, so be prepared to pay taxes on the inherited amount.
It's a good idea to consult with a financial advisor to determine the best course of action for your individual situation.
Beneficiary Options
As you consider opening an inherited IRA account, it's essential to understand your options as a beneficiary. You have several choices, which depend on your relationship to the decedent and the type of account inherited.
Spousal beneficiaries have the most options, including taking a lump-sum distribution, rolling over inherited funds into their personal IRA, or transferring the inherited proceeds into an Inherited IRA. They can also choose to delay required minimum distributions (RMDs) as long as possible.
For non-spousal beneficiaries, options are more limited. They can take a lump-sum distribution, disclaim the proceeds, or transfer the inherited funds into their own Inherited IRA. Non-natural beneficiaries, such as charities or businesses, can also choose to take a lump-sum distribution or transfer the funds into an Inherited IRA.
As a beneficiary, it's crucial to consider the tax implications of your choices. If you inherit a traditional IRA, any amount withdrawn is often subject to taxes. However, if you inherit a Roth IRA, you're free of taxes.
Here are some key options to consider:
- Lump-sum distribution: Take the entire amount at once, which is taxable to the beneficiary.
- Roll over inherited funds: Transfer the funds into your personal IRA, which can provide tax benefits.
- Transfer to Inherited IRA: Transfer the inherited proceeds into an Inherited IRA, which can provide tax benefits and flexibility.
- Disclaim the proceeds: Transfer full rights to remaining beneficiaries or the decedent's estate.
- RMDs: Required minimum distributions can be based on the beneficiary's age or the decedent's age at the date of death.
It's essential to carefully consider your options and consult with a trusted financial advisor or accountant to ensure you make the best choice for your situation.
Spousal Inheritance
Spouses have more flexibility when it comes to handling an inherited IRA. They can roll over the IRA, or a part of the IRA, into their own existing individual retirement accounts.
The advantage of this rollover is the ability to defer required minimum distributions (RMDs) of the funds until they reach the age of 73. This is a significant benefit, as RMDs previously began at 70½, but the age was raised to 72 following the December 2019 passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act.
Spousal heirs can also set up a separate inherited IRA account. If the original owner had already begun receiving RMDs at the time of death, the spousal beneficiary must continue to receive the distributions as calculated or submit a new schedule based on their own life expectancy.
If the owner had not yet committed to an RMD schedule or reached their required beginning date (RBD), the beneficiary of the IRA has a five-year window to withdraw the funds, which would then be subject to income taxes.
Here are the options for a spousal beneficiary:
- Take a lump-sum distribution
- Roll over inherited funds into your personal, like-kind IRA
- RMD: Required minimum distributions are based on your age and are calculated using the IRS Uniform Lifetime Table life expectancy factors
- Transfer the inherited proceeds into an Inherited IRA
- RMD: Unlike a Traditional IRA, the timing of the required minimum distribution is based on the decedent's age at the date of death and is calculated using the IRS Single Life Expectancy Table life expectancy factors
- Disclaim the proceeds
A surviving spouse can treat the IRA as their own, designating themselves as the account owner. They can also roll it over into their own, pre-existing IRA. Finally, they can treat themselves as the account beneficiary.
Consider reading: Can I Open My Own 401k Account
Tax and Distribution Rules
If you inherit an IRA, you'll need to understand the tax and distribution rules to avoid penalties and taxes. Beneficiaries of traditional IRAs are responsible for making sure the original account owner's required minimum distribution (RMD) is taken care of in the year of death.
The RMD age is 73 years, and if the account owner dies before reaching this age, the five-year rule applies. This means the beneficiary must withdraw the remaining balance of the account over a five-year period following the owner's death.
The payout rule is used if the owner died after reaching the RMD age, and the beneficiary can withdraw the remaining balance based on the owner's remaining life expectancy. Each year, the beneficiary must take out a certain minimum amount (RMD), but they can choose to withdraw more if desired.
Here's a summary of the RMD rules for beneficiaries:
Spousal beneficiaries can delay RMDs until the year the original owner would have turned 73, and then calculate RMDs based on their own life expectancy. Non-designated beneficiaries, on the other hand, must set up a new account and follow the applicable RMD rule.
Required Distributions
If you inherit a traditional IRA, you'll need to take required minimum distributions (RMDs) to avoid penalties. The RMD age is currently 73 years old, but this can be delayed until the year in which the deceased individual would have turned 73 or December 31 of the year following their death.
You can calculate your RMD by dividing the IRA's balance on December 31 of the previous year by the distribution period found in Table III for the account owner's age on their birthday this year. For example, if the account owner died in 2020 or later, a spouse would have several options, including rolling over the account owner's IRA into their own account or delaying taking RMDs until the account owner would have turned 72 years old.
If the original owner passed away before December 31, 2019, the required minimum distribution will be based on the beneficiary's age using the single life expectancy factor. However, if the original owner passed away on or after January 1, 2020, the proceeds will be paid out within 10 years from the original owner's date of death.
Non-spousal beneficiaries, including natural persons and non-natural persons, have different rules for RMDs. For non-natural persons, funds can be distributed as a lump sum or transferred into an Inherited IRA in the name of the beneficiary. For natural non-spousal beneficiaries, funds can be taken as a lump-sum distribution, which is taxable to the beneficiary, or transferred into their own Inherited IRA.
Here are the key dates to keep in mind for RMDs:
- December 31 of the year following the year of death
- The year in which the deceased individual would have turned 73
- December 31 of the year in which the account holder would have reached 73
By understanding these rules, you can ensure that you're taking the correct RMDs and avoiding penalties.
Converting Pre-Tax Retirement Accounts to Roth
You can convert a pre-tax retirement account to a Roth IRA, but there are specific rules to follow. If you're a non-spouse beneficiary of an employer-sponsored retirement plan, you can roll over your inherited assets into an inherited Roth IRA.
The entire account balance will be added to your taxable income in the year of transfer, and you'll be subject to the 10-year rule for distributions. This means you'll have to take distributions within 10 years of the transfer.
Additional reading: Roth Ira Basis
As a spouse beneficiary, you have more flexibility. You can treat the inherited assets as your own and roll them over into your own retirement account.
If you're a spouse beneficiary, you can convert the inherited assets to a Roth IRA after rolling them over into your own account. This will require paying taxes in the year of transfer, but you'll benefit from tax-free distributions going forward.
Remember, if you're a non-spouse beneficiary, you're not allowed to convert an inherited Traditional IRA into an inherited Roth IRA.
Open an Account
Opening an inherited IRA account can be a bit complex, but don't worry, I'm here to guide you through it.
You can open an inherited IRA and transfer the funds into that account, which is a great way to manage the inherited assets.
To delay required minimum distributions (RMDs), you have the choice between two options: the year the deceased individual would have turned 73, or December 31 of the year following the year of their death.
Distributions must commence no later than December 31 of the year in which the account holder would have reached 73, to ensure compliance with RMD requirements.
You can open an inherited IRA using the proceeds from any type of IRA, including traditional, Roth, rollover, SEP, and SIMPLE IRAs.
To do this, you'll need to transfer the assets from the deceased individual's IRA into a new inherited IRA in your name.
Here are the types of IRAs you can use to open an inherited IRA:
- Traditional IRA
- Roth IRA
- Rollover IRA
- SEP IRA
- SIMPLE IRA
You cannot make additional contributions to an inherited IRA, so keep that in mind as you manage the account.
The Internal Revenue Service provides guidelines for inherited IRA beneficiaries, which you'll need to follow when reporting inherited IRAs and their distributions for tax purposes.
You'll need to use IRS forms 1099-R and 5498 for this purpose.
Understanding the Secure Act
The SECURE Act made a big impact on inherited retirement accounts, making the rules more complicated. It introduced a new option for distributing account assets and defined a third category of beneficiaries.
The Act also changed the age at which Required Minimum Distributions (RMDs) are required to begin, increasing it from 70½ to 72. For those who turned 70½ in 2019, the RMD age is still April 1, 2020, but those who turn 72 in 2020 or later can wait until April 1st of the year following their 72nd birthday.
The SECURE Act 2.0, passed in December 2022, further updated the RMD age, stating that if you turn 73 between 2023 and 2032 your RMD age is 73, and it's scheduled to increase to age 75 in 2033.
Expand your knowledge: Secure Act Inherited Ira
The 10-Year Rule
The 10-Year Rule is a significant change under the SECURE Act that affects how inherited IRAs are taxed. This rule applies to non-spouse beneficiaries who inherited an IRA in 2020 or later.
The 10-year rule requires the value of the inherited IRA to be zero by December 31 of the 10th anniversary year of the original owner's death. This means that beneficiaries must withdraw the entire balance of the IRA within a decade.
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The SECURE Act also introduced a new group of beneficiaries who are exempt from this rule. These beneficiaries include spouses, individuals not more than 10 years younger than the IRA owner, and individuals who are chronically ill or disabled.
You may be wondering who exactly qualifies as an "eligible designated beneficiary." According to the SECURE Act, this includes minor children of the original account holder, up to age 21, as well as individuals who are chronically ill or permanently disabled and are not more than 10 years younger than the IRA's original owner.
Here's a quick rundown of the beneficiaries who are exempt from the 10-year rule:
- Spouses
- Individuals not more than 10 years younger than the IRA owner
- Disabled or chronically ill individuals
- Minor children (until they attain majority)
Keep in mind that this new rule only applies to inheritances that occurred in 2020 or later. If you inherited an IRA before this time, the old rules still apply.
The Secure Act
The SECURE Act made significant changes to inherited retirement accounts, making them more complicated. The act allowed for a new option for distributing account assets and defined a third category of beneficiaries.
The age at which Required Minimum Distributions (RMDs) are required to begin was increased from 70½ to 72. This change effectively altered the Required Beginning Date (RBD).
For those who turned 70½ in 2019, the RBD is still April 1, 2020. However, those who turn age 70½ in 2020 or later can wait until April 1st of the year following their 72nd birthday.
The SECURE Act 2.0 updated the RMD age in December 2022. If you turn 73 between 2023 and 2032, your RMD age is 73, and it's scheduled to increase to age 75 in 2033.
Most non-Exempt Designated Beneficiaries (EDBs) who inherit an IRA on or after January 1, 2020, may no longer use the Stretch IRA strategy. This change applies to both Roth IRAs and pre-tax IRAs.
Key Considerations
Opening an inherited IRA account can be a complex process, but understanding the key considerations can help you make informed decisions.
You may have to take Required Minimum Distributions (RMDs) depending on your age, or you may have to fully withdraw the money in 10 years if you treat the IRA as your own.
As a surviving spouse, you can roll over the inherited IRA into your own account, but this privilege is exclusive to you.
You have other options for taking the money, each with their own set of rules and tax implications.
You may be able to let the money continue to grow in the IRA until you reach age 72, but this depends on your circumstances.
Here are some key options to consider:
- Treat the IRA as if it were your own, naming yourself as the owner.
- Treat the IRA as if it were your own by rolling it over into another account, such as another IRA or a qualified employer plan.
- Treat yourself as the beneficiary of the plan.
It's essential to review all your options with a trusted financial advisor or accountant who understands your financial situation and has expertise in managing financial inheritances.
For your interest: Financial Accountant
Frequently Asked Questions
What's the best thing to do with an inherited IRA?
Consider using the inherited IRA funds to supplement your income, reducing your take-home pay and maximizing your workplace 401k contributions, or transferring them to a taxable investment account for more flexible management. This can help you optimize your retirement savings and minimize taxes.
What is the disadvantage of an inherited IRA?
Inheriting a traditional IRA can be costly, as withdrawals are subject to ordinary income taxes. This tax liability is a key disadvantage of inheriting a traditional IRA.
What is the new IRS rule on inherited IRA?
The "10-year rule" requires non-spousal, minor child, disabled, chronically ill, or certain trust beneficiaries to empty inherited IRAs within 10 years of the original account owner's death. This rule applies to accounts inherited since 2020.
Sources
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