Considerations When Inheriting an IRA

Posted on Tue, Jan 04, 2022 ©2021 Drucker & Scaccetti

Investment-GrowthBy: Matt Lebo, CPA

 

When inheriting an IRA (Roth or Traditional) you may wonder about available choices regarding the account title as well as distributions. Are distributions required? If so, how long do you have to take these distributions and when do these distributions begin? Are you eligible to move the IRA to your own name; and, if so, should you do this, or must the account name reference the decedent and their date of death? What are the tax implications of these choices? Today, we’ll answer these questions and more as we explore inheriting an IRA.

 

The complex rules that regulate inherited IRAs were significantly modified by the SECURE Act, which was enacted in December of 2019. Some of the more significant changes under the Act were the general elimination of the “stretch IRA” and creation of a new 10-year rule, raising the required minimum distribution age to 72 and creating an additional class of beneficiaries called Eligible Designated Beneficiaries.

 

With the general elimination of the stretch IRA, a special class of beneficiaries called Eligible Designated Beneficiaries (EDBs) was created to allow these beneficiaries the special benefit of withdrawing from the inherited IRA account more slowly and, thus, enable income and growth of the assets to continue for a lengthy, tax-deferred period.

 

EDBs include the following four categories:

 

  1. Surviving spouses
  2. Chronically ill beneficiaries
  3. Disabled beneficiaries
  4. Minor children of the account owner (up to the age of majority, or 26 if the child is still in school)

 

Meeting one of these four designations is advantageous because you are permitted to use the pre-SECURE Act stretch IRA rule. This means you can take distributions over the life of the beneficiary and there is no period when you are required to completely drain the account. However, EDBs must take required minimum distributions (RMDs) whether the account is a ROTH IRA or a Traditional IRA, based on the pre-SECURE Act rules. Remember, for ROTH IRAs, if the assets have been in an original ROTH IRA owner’s account for 5 years or more, these RMDs are 100% tax-free, whereas the withdrawals from a Traditional IRA are taxable.

 

The ability to still use the stretch IRA is extremely advantageous. With money withdrawn more slowly over one’s life expectancy, the annual withdrawals are smaller, and one typically pays a lower effective annual tax rate. Even more importantly, the longer you defer distributions, the longer the money can continue compounding within the account on a tax deferred basis.

 

Of the four eligible designated beneficiary categories, making your spouse the sole beneficiary maximizes options outside of the stretch IRA. For example, via a spousal transfer it is possible to roll the assets from the original owner’s account into a spouse’s existing IRA or into a new IRA account titled to the spouse. When you choose this option, the inherited IRA is treated the same as if it was originally the spouse’s account, and the spouse can delay any RMDs until they turn age 72. A spousal transfer is great for beneficiaries who are younger than the deceased spouse and may not yet need the income. However, after doing this, if the spousal beneficiary of the IRA were to take distributions prior to reaching age 59½ they would be subject to a 10% early-withdrawal penalty unless one of the IRS penalty exceptions applies.

 

Should you decide not to utilize the spousal transfer or if a beneficiary is not the spouse and is an EDB, you would need to set up a separate inherited IRA for each decedent as you transfer assets from the decedent. From there you must take annual distributions based on your own life expectancy beginning with the year after death of the original account owner. You will not incur the 10% withdrawal penalty for distributions taken under the age of 59½ on an inherited account if you are receiving RMDs. This is the stretch IRA concept mentioned earlier, which gives the assets in the IRA the benefit of time to use the power of compound interest to grow the account on a tax-deferred basis. Eligible designated beneficiaries #2, #3, and #4 also qualify for this same treatment.

 

However, if a minor child of the account owner is inheriting an IRA, as soon as they reach the age of majority, you can no longer take advantage of the stretch IRA and must use the new 10-year rule for your inherited IRA withdrawals (explained below). Also, if an EDB passes away, the next beneficiary receiving such IRA assets must distribute the interest using the new 10-year rule regardless of any designations.

 

It is critical that you understand what type of beneficiary you are. If a beneficiary is NOT an EDB meeting the EDB definitions, and the original retirement account owner died after December 31, 2019*, the remaining account balance must be completely distributed to the beneficiary within 10 years after the date of death of the original account owner. Here is where these distributions get a little dicey.

 

Despite some original confusion by the IRS in its interpretation of the 10-year rule under the SECURE ACT, those utilizing the 10-year rule have no annual distribution requirement for the first nine years after the death of the decedent, but are instead required to drain the account before the end if the tenth year following the decedent’s death. The IRS has now confirmed that the account can continue to grow tax-deferred with compounding for 10 years and then be distributed in its entirety up to the very last day of the 10-year period following the year of death.

 

Since there are no annual RMDs required under this 10-year rule, carefully plotting out when to voluntarily withdraw from the deferred account based on your tax bracket in each year of the 10-year period may achieve better results when compared to draining the inherited IRA all in the 10th year, when taking a huge lump sum could result in a higher tax average tax bracket and more being paid to Uncle Sam.

 

Inherited IRAs are a complex topic. If you need help with understanding your inherited IRA choices, we are here for you. Please give Drucker & Scaccetti a call to discuss the changes brought on by the SECURE Act and its potential impact on you.

 

*Pre-SECURE Act laws apply to beneficiaries who inherited qualified retirement accounts prior to January 1, 2020.

Topics: Inherited IRA, beneficiaries, SECURE act, Stretch IRAs

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