What Happens When You Inherit an IRA?

Inheriting an IRA creates important tax decisions that affect how much of your inheritance you ultimately keep. The rules depend on your relationship to the original owner, whether they had begun required minimum distributions, and when they passed away. Making the wrong choice can accelerate taxes unnecessarily, while the right strategy may help spread those taxes over several years.

This is the second article in our Inheritance series; if you wish to learn more about the basics of inheriting money, be sure to visit our first article—Inheriting Money: What you Need to Know About Taxes, Probate and Next Steps

What if I Inherit My Parent’s IRA?

The SECURE Act signed into law in 2019 and effective when the death of an IRA owner occurs on or after January 1, 2020, changed the tax rules for most non-spouse beneficiaries. Congress determined that IRAs are meant to provide retirement income for the original IRA owner and not a tax-deferred legacy for heirs for generations. Congress wants the tax revenue sooner rather than later. According to the Congressional Research Service, changing the distribution of IRAs inherited by most adult non-spouse beneficiaries from their own life expectancy to the 10-Year Rule is estimated to bring $15.7 billion into the federal coffers from 2020 to 2029.

The 10-Year Rule for Designated Non-spouse Beneficiaries

It is important to record the name of your beneficiary(ies) with the custodian of your IRA. When beneficiaries are identified on the IRA account, they are called “Designated Beneficiaries.”

Under the SECURE Act, a Designated Beneficiary, who is not a spouse or otherwise eligible for a special exception, must withdraw all the funds and pay the income tax based on their own income tax return by December 31 of the tenth year following the original IRA owner’s death, The 10-Year Rule.

If the IRA owner died before their Required Beginning Date (RBD) then annual distributions are not required. The Beneficiary must withdraw all the funds by the end of the 10th year. They can choose to draw some throughout the 10-year period, but they are not required to. It is wise to carefully monitor your personal income tax liability each year and try to take distributions when your income is lower or you have extra deductions to help offset the additional income created by the IRA distributions.

If the IRA owner died on or after their RBD, the beneficiary must take a minimum amount each year based on the Single Life Table for beneficiaries starting with the beneficiary’s age in the year the IRA owner died. Their age determines the beginning factor. Each subsequent year a new factor is created by subtracting 1 from the previous year’s factor. They are still required to receive the entire balance no later than December 31 of the tenth year following death.

The 10-Year Rule, instituted for deaths that occur on or after January 1, 2020, both accelerates and increases the income tax that will be paid and reduces the net to the beneficiary. The distributions are taxed at the marginal income tax rate of the beneficiary. Because our tax rates are progressive, the higher your income the higher the rate you pay on the top dollar.

Planning Considerations

If you inherit an IRA while you're still working, the distributions from the IRA will be added to your earned income and may push you into a higher income tax bracket. If you’re close to retirement age you could minimize the benefits you receive in the early years, and then after you retire you could receive larger IRA distributions. The goal is to take IRA distributions in years when your other income is lower.

Another strategy is to maximize your own employer 401K contributions while you're working, and draw distributions from your beneficiary IRA to replace the income deficit and meet the 10-Year deadline. It is a backdoor way to transfer the Inherited IRA to your own 401k.

If you would like to learn more about coordinating IRA Distributions with other income sources, visit our other article How to Reduce Future RMDs: 5 Tax-Efficient Strategies for Retirees.

What if you pass away before receiving all of the Inherited IRA?

When you set up an Inherited IRA you should name your own beneficiary. If you pass away before receiving all of the Inherited IRA, your beneficiary will receive the funds over the remaining years to the 10th anniversary of the original owner’s death. Only one 10-Year Rule applies.

Beneficiaries should consult a financial advisor or tax specialist to plan wisely for these taxable distributions.

Who Are Eligible Designated Beneficiaries (EDB)?

There are five categories of EDBs, and they are exempt from the SECURE Act changes. These are “designated beneficiaries” which means they must be named on a beneficiary form with the custodian of the IRA. In addition, they are “eligible” based on one of the following five criteria. They may use their Life Expectancy to receive IRA funds when the proceeds are properly held in an Inherited IRA, and they are not subject to the 10-Year Rule.

Surviving Spouses
Decedent’s Minor Children
Chronically Ill Beneficiaries (as defined by IRC Section 7702B(c)(2))
Disabled Beneficiaries (as defined by IRC Section 72(m)(7))
A Beneficiary not more than 10 years younger than the decedent

A spouse has the most favorable tax options when inheriting an IRA. We will explain these options in detail in the next section of this report.

A decedent’s minor children, that is children who are under age 21, are allowed to use their Life Expectancy to receive distributions from an Inherited IRA. They must take a Required Minimum Distribution beginning in the year following the death of their parent which is calculated on the Single Life Expectancy Table for Beneficiaries. They start with a factor based on their age in the year following the parent’s death and subtract 1 each subsequent year to calculate the annual RMD.

Age 21 is a federally defined age of majority, and it overrides any state rule which may be younger. When the minor turns 21 they will be under the 10-Year Rule. They must continue receiving an RMD annually based on the original calculation of deducting 1 each year and by the 10th year, the year they turn 31, they must receive the balance of any funds in the account.

This only applies to minor children of the decedent. It does not apply to grandchildren or nieces or nephews.

Chronically Ill Beneficiaries and Disabled Beneficiaries as defined by the applicable IRS Codes are allowed to use the Single Life Expectancy Table for Beneficiaries until their death. After their death, their beneficiaries must use the 10-Year Rule.

Beneficiaries not more than 10 Years Younger than the decedent are also allowed to use the Single Life Expectancy Table for Beneficiaries until their death. This might include siblings, other relatives, or friends of the original IRA owner. At their death, their beneficiaries must use the 10-Year Rule.

What Happens When a Spouse Inherits an IRA?

A surviving spouse has the most favorable tax treatment when inheriting an IRA. There are a couple of options, and the best choice depends upon the age of the survivor.

A surviving spouse is the only heir who is allowed to rollover the IRA from the deceased partner into their own IRA. The money can be combined with an existing IRA in the survivor’s name. The proceeds of the IRA will continue to be tax-deferred until withdrawn. Required Minimum Distributions will be based on the surviving spouse’s own life expectancy on the Uniform Lifetime Table. RMDs begin at age 73. For survivors who are over age 59 ½ this may be the best choice.
The second option available to a surviving spouse is to place the money in an Inherited IRA. If the survivor is under age 59 ½ this option allows them to take distributions without an early withdrawal penalty. The Life Expectancy calculation for a Spousal Inherited IRA depends upon whether the deceased partner had reached the Required Beginning Date (RBD) before death. RBD is the date when Required Minimum Distributions must begin, which is usually April 1 of the year following their 73rd birthday.

If the deceased spouse died before reaching the Required Beginning Date, the money may remain tax deferred until the date when they would have reached their RBD. Then the survivor must begin receiving Required Minimum Distributions based on their own life expectancy on the Single Life Table for Inherited IRAs.
If the deceased spouse died on or after their RBD, Required Minimum Distributions must begin the year following the original owner’s death. The calculation will be the longer of the surviving spouse’s life expectancy based on the Single Life Table for Beneficiaries or the remaining life expectancy of the deceased.

Planning Considerations

For surviving spouses who are under age 59 ½ usually the best option is to set up an Inherited IRA to receive the proceeds as the beneficiary. If the original owner was also young, this strategy has the potential to extend the tax deferral for many years. At the same time, there is no early withdrawal penalty if early distributions are needed. When the beneficiary turns 59 ½, if they are the younger of the couple, rolling the proceeds into an IRA in their own name at that time will result in the longest deferral period.

If the deceased was younger than the survivor, then continuing to hold the Inherited IRA past the survivor’s age 59 ½ will result in the longest deferral period. Required Minimum Distributions are not due until the original owner would have been 73.

When the survivor is over 59 ½ and the deceased was the older of the two of them, usually rolling the proceeds into the survivor’s IRA makes the most sense. It is notable that this option gives the survivor’s heirs the full ten-year withdrawal period, too.

Always consult a financial advisor or tax specialist to discuss your own specific situation and receive personalized advice.

What Happens if a Non-Designated Beneficiary Inherits an IRA?

A non-designated beneficiary is a charity, an estate, or a trust. These entities do not qualify as Designated Beneficiaries. They are non-persons.

If you name a qualified charity to receive your IRA account, no tax will be due on the proceeds because charities are tax-exempt entities.

There are special rules when IRA proceeds are left to a trust. Most professionals do not recommend naming a trust as the beneficiary of an IRA unless you have special circumstances where a trust is necessary. You should seek help from a professional knowledgeable with trust rules and qualified plans to minimize the tax liability.

If you name your Estate as your beneficiary or do not name a beneficiary at all, it is called a non-designated beneficiary. Your IRA is subject to the 5-Year Rule and proceeds are paid to the beneficiary named in your will.

A Tale About an Inherited IRA

Once upon a time Sally inherited a $1,000,000 IRA from her father. Unfortunately for Sally, her father forgot to change his beneficiary designation after her mother passed away. Sally’s mother was still listed as his only beneficiary on the IRA account at the time of his death. Because Sally was not named, the IRA had to pass through his estate instead of going directly to Sally.

If the beneficiary is someone other than a spouse, there are two possible outcomes depending on the age of the IRA owner.

If the IRA owner died before his RBD, the 5-Year Rule applies. The IRA proceeds are paid out by December 31 of the fifth year following the IRA account owner’s death. The money can be distributed in partial distributions over the 5 years, or in a lump sum by the December 31deadline.
If the IRA owner died on or after their RBD, the distributions are based on the IRS Single Life Expectancy Table for Inherited IRAs. You begin with the factor for the owner’s age in the year of death and subtract 1 for each year going forward until the account is fully distributed. RMDs must continue annually with the full distribution by the end of the 5th year.

Sally’s Option

Sally’s father was 87 years old when he died. He was already past his RBD and receiving Required Minimum Distributions annually. Sally’s only option was #2 above. The life expectancy factor for an 87-year-old is 7.1. Sally had 7 years to distribute the entire account, and she was required to take at least the required minimum each year beginning the year following her father’s death.

In the year following death, Sally had to take at least $163,934, that is 1,000,000 divided by 6.1. Each year the factor is reduced by 1 and divided into the value of the IRA on the last day of the previous year. The proceeds were taxable on Sally’s personal income tax return.

What would have provided a better outcome for Sally?

If Sally was named as a Designated Beneficiary with the IRA custodian, her distributions would have come under the 10-Year Rule.

What are Some Common Mistakes When Inheriting an IRA?

A common mistake is failing to update beneficiary designations. Sally's story is a good illustration of how that impacts taxes and the net inheritance received by an heir. It's important to name your own beneficiary on an inherited IRA as well.
Waiting too long to contact the custodian of an IRA may create some tax problems. The Beneficiary Determination Date is September 30th of the year following the IRA owner's death. There may be Required Minimum Distributions to take before December 31st of the year following the IRA owner's death. If the IRA was left to a trust, then the trust must notify the custodian and submit trust documentation before October 31st of the year following the IRA owner's death. You can prevent some of these issues by getting in touch with the custodian promptly.
A common mistake is to assume that you have 10 years in which to receive the IRA distributions and miss some Required Minimum Distributions annually. There are penalties for beneficiaries who don't withdraw required minimum distributions in a timely fashion.
Unless it is a very small IRA, it's a mistake to take the entire balance in one year. Under our progressive tax system, the more you earn, the more you pay. Hence, you want to be careful not to put yourself into a higher tax bracket by taking all the money in one year.
It's a mistake to assume that your will overrides beneficiary forms. Some people assume that their will takes care of everything, and they fail to name beneficiaries on their IRA accounts.

Recommendations

IRAs are often a substantial part of a person's estate. If you are an IRA owner, it's important to seek professional advice to make sure that your assets will transfer according to your wishes in the most tax efficient way possible.

If you are a beneficiary, it's important to know all your options before making any decision on how to receive inherited IRA benefits.

At Guelich Capital we help our clients across the Roanoke Valley and Southwest Virginia to make wise decisions to minimize taxes and transfer their IRAs in the most tax efficient way possible.

This article is for educational purposes only. It should not be considered tax, investment or legal advice. Consult a qualified professional regarding your own specific situation.

Written by Connie C. Guelich, CFP® this article represents our views at the time written, and it is subject to change.