Inherited IRA Rules: What Beneficiaries Need to Know
Before 2020, inheriting an IRA featured a powerful estate-planning strategy (the "stretch IRA”), whereby the account owner would name younger beneficiaries—children, grandchildren, or even great-grandchildren—instead of a spouse in order to pass along assets in the account from one generation to the next while taking advantage of long-term, tax-deferred growth.
Related laws are much different today, however, as the SECURE Act 1.0 (effective as of January 1, 2020) largely ended the stretch IRA strategy. In this post, we’ll break down your inherited IRA (AKA “beneficiary IRA”) options given the updated rules applying to traditional, rollover, SEP, or SIMPLE IRAs unless otherwise noted.
Inherited IRA beneficiary classes
Inherited IRA rules are complex, your relationship to the deceased and both your ages determining which of three beneficiary categories apply here…
Eligible designated beneficiaries (EBDs)
Eligible designated beneficiaries include a surviving spouse, minor child of the account owner, chronically ill or disabled individual, someone 10 or fewer years younger than the account owner, and some trusts.
Designated beneficiaries (DBs)
Designated beneficiaries are typically adult children, beneficiaries more than 10 years younger than the original account owner, or other individuals who don’t meet the criteria for eligible designated beneficiaries.
Non-designated beneficiaries (NDBs)
This third beneficiary category extends to charities, some trusts, and the original account owner’s estate.
These distinctions are important since different rules apply to each group.
Inherited IRAs: concepts to know
Before diving into the specific rules, it's helpful to first understand a few key concepts shaping how inherited IRAs work…
10-year rule for inherited IRAs
The 10-year rule says beneficiaries must withdraw all funds from an inherited IRA within 10 years of the original owner's death. If the account holder passes away in 2026, for example, you have until December 31, 2036, to fully distribute the funds and close the account—with the freedom to withdraw any amount at any time during those 10 years, knowing the IRS could hit you with a steep penalty (up to 50% of the remaining balance) if you fail to empty the account by the deadline.
Taxable inherited IRA distributions
While inherited traditional IRA withdrawals are generally taxable as income, distributions are generally tax-free if you inherit a Roth IRA so long as the account has been open for at least 5 years. If the Roth IRA is less than 5 years old, you won't pay taxes on contributions withdrawn but will owe income tax on any earnings taken out.
Required minimum distributions (RMDs)
RMDs are the minimum amount of money you must withdraw from specific tax-deferred retirement accounts—including IRAs—each year beginning at age 73, climbing to age 75 in 2033. RMDs are important to understand since inherited IRAs rules can change depending on whether the original account holder was already taking RMDs or supposed to start. RMDs are calculated based on life expectancy factors set by the IRS; younger spouses who inherit a 401(k) and are allowed to use their own life expectancy for RMDs often benefit since their annual withdrawal requirements are often much lower than those of their older counterparts.
Inherited IRA rules for spouses
Surviving spouses are considered eligible designated beneficiaries (EDBs) and enjoy the most leeway overall; beneficiaries of a spouse's IRA have several options when it comes to managing these inherited assets including…
Taking a lump-sum withdrawal
In choosing what amounts to the most straightforward option, you’d withdraw the entire balance at one time though would be subject to income taxes on this same amount—the transaction possibly bumping you into a higher tax bracket, forcing you to pay more in taxes than you initially expected.
Rolling over assets into your own IRA
Spouses have a unique privilege no other beneficiary enjoys: the ability to roll over inherited assets into their own IRA—either a new or existing account—per standard IRA rules, especially advantageous when an older spouse passes away and the money isn’t needed right away.
In choosing this option (only available to sole beneficiaries), you can make pre-tax contributions, let your savings grow tax-deferred, and name your own account beneficiary. You can also defer required minimum distributions (RMDs) until age 73 (rather than continue your spouse’s RMD schedule) if he or she was at least 73 years old at the time of death. Remember, however, that if your spouse had already begun taking RMDs but didn’t fulfill the required amount before passing, you'll need to go ahead and follow suit for the current year.
Remaining an inherited IRA beneficiary
Another option is to transfer assets to an inherited IRA and remain a beneficiary, with the IRA staying in the original account holder’s name. This is often a good choice for those older than a spouse who was under the age of 73 at the time of passing since you can delay taking RMDs until the year he or she would’ve turned this same age.
Remaining a beneficiary can also benefit widows under the age of 59½ who need access to inherited funds; in doing so, they can avoid the 10% early withdrawal penalty typically applying to retirement accounts including IRAs. A few significant drawbacks are associated with this route, however, including that you can’t make contributions and this type of IRA isn’t protected from creditors under federal bankruptcy law—dictating those not in a healthy financial situation tread carefully here.
Converting assets to a Roth IRA
A fourth choice is to convert inherited assets into a Roth IRA (a "Roth conversion"), a viable option for spouses who anticipate occupying a higher tax bracket in the future. Keep in mind tax implications, however, as taxes will apply to the converted amount. A Roth conversion is also sometimes a beneficial choice for spouses seeking to avoid required minimum distributions (RMDs) and wanting to leave their heirs a tax-free inheritance.
Disclaiming the inheritance
A final option is to disclaim the inheritance, doing so (as required) within 9 months of the original owner’s death and thus allowing the assets to pass to a contingency beneficiary, trust, or charity. This option, primarily utilized by those who don’t need the assets nor want the additional income due to potential estate tax consequences, is an irrevocable decision that cannot be reversed.
Inherited IRA rules for non-spouses
Non-spouse IRA beneficiaries are individuals such as a child, grandchild, sibling, other relative, or friend of the original account owner and fall into two categories: eligible designated beneficiaries and designated beneficiaries.
Options for non-spouse eligible designated beneficiaries (EBDs)
Non-spouse eligible designated beneficiaries—often a minor child or sibling less than 10 years younger than the account owner—have several inherited account options including taking a lump-sum distribution of the entire amount, adapting the 10-year rule, taking annual distributions, or disclaiming the inheritance. Consider the following key points if you fall into this category…
Inherited IRAs and adults
Eligible designated beneficiaries who are adults have the option to stretch their inherited IRA distributions over their lifetime by using their own life expectancy for calculating RMDs, thus allowing them to extend distributions beyond 10 years. Here’s how this works:
If the original account owner passed away before reaching RMD age
In this case, you can either adapt the 10-year rule or take annual distributions from the IRA over your own life expectancy, which for younger beneficiaries would mean taking smaller RMDs each year and a depletion period of more than 10 years.
If the original account owner passed away after reaching RMD age
If the original account owner was already taking RMDs at the time of death, you must continue doing so for that same year if the action wasn’t already taken. The 10-year rule then applies from there.
Inherited IRAs and minors
Minors aren't legally allowed to own property (meaning they cannot inherit an IRA directly), so most people designate a custodian—typically the minor's legal guardian—or a trust to manage the funds until the beneficiary reaches the age of majority. Furthermore, minor children designated as beneficiaries must then follow the 10-year rule upon reaching the age of majority, typically between 18 and 21 years old depending on the state of residence. An exception exists for minors who are children of the account owner, however, whereby they can withdraw from the inherited IRA with the 10-year rule applying to remaining funds when they reach the age of majority.
Disabled beneficiaries
To be considered “disabled,” one must meet criteria defined in IRC Section 72(m)(7). With respect to a “chronically ill” designation, meanwhile, an individual must be unable to perform at least two of six activities of daily living (ADLs)—eating, toileting, transferring, bathing, dressing, or continence—for a period of 90 days.
Options for designated beneficiaries (DBs)
Non-spouse IRA beneficiaries not classified as an eligible designated beneficiary (EDB)—typically an adult child—have four options. They can either take a lump-sum payment, establish a new inherited IRA, or disclaim the proceeds. Key rules to consider extend to the following circumstances…
If the original account owner passed away before reaching RMD age
If the original account owner died before reaching the age for RMDs, you can move the inherited assets into an inherited IRA and choose when and how much to withdraw—so long as the entire account is emptied within 10 years.
If the original account owner passed away after reaching RMD age
If the original account owner was already taking RMDs at the time of death, you must continue doing so for the year of death if the action wasn’t already taken. The 10-year rule then applies from there.
Inherited IRA rules for multiple beneficiaries
If you’re inheriting an IRA and aren’t the only beneficiary—a common occurrence, especially when siblings are involved—each beneficiary must transfer his/her respective shares into separate inherited IRAs by December 31 of the year following the owner's death (known as the “separate account” or “separate share” rule). From there, they can follow the rules outlined earlier based on which beneficiary category they belong to. Should the beneficiaries fail to establish separate accounts by the December 31 deadline, all will need to take RMDs based on the beneficiary with the shortest life expectancy (i.e., the oldest) beginning the year after the owner's death.
Inherited IRA rules for trusts, entities, & charities
A third beneficiary category—“non-designated beneficiaries”—exists for charities, some trusts, and the original account owner’s estate. If this is relevant to you, know that the age of the original account owner determines how you distribute these assets, as follows…
If the original account owner passed away before reaching RMD age
If the original owner was under the age of 73, for example, you must completely distribute the assets by December 31 of the fifth year following the original owner's death (commonly referred to as the "5-year rule").
If the original account owner passed away after reaching RMD age
If the original account owner was required to take RMDs at the time of death, you're generally required to do the same based on his/her life expectancy. If the original owner did not take RMDs but was obliged to, you must take an RMD from the inherited account by December 31 of the year of his/her death.
Inherited Roth IRA rules
Withdrawal rules for a Roth IRA inheritance are quite similar to those for other types of IRAs. Spouses who inherit a Roth IRA, for example, have the same options at their disposal that mimic all other IRAs. A non-spouse eligible designated beneficiary can choose to take a lump-sum distribution of the entire amount, withdraw funds based on his/her life expectancy, or follow the 10-year rule—with the 10-year rule applying for all other Roth IRA heirs. Key Roth IRA distinctions are that withdrawals are tax-free so long as the account you inherited was at least 5 years old and you’re at least 59½ years old, with no need to worry about RMDs.
In summary: inheritance rules for traditional and Roth IRAs
As you can see, laws regarding inherited IRAs have become pretty complicated over the last few years. It’s therefore imperative to partner with a trusted financial advisor who can guide you through options unique to your own personal financial situation and help you avoid any costly missteps.
Still have questions about inherited IRAs? Schedule a FREE discovery call with one of our financial advisors to get them answered.
FAQs
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Yes, a penalty tax of up to 25% on the amount that should have been withdrawn indeed applies if the missed RMD is not taken.
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In order to do this, simply open an inherited IRA account with the new custodian in your name as the beneficiary. Then, request a direct trustee-to-trustee transfer from your current custodian. Be sure to keep the account titled as an inherited IRA so you can continue to enjoy the corresponding tax benefits.
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Only spouses can treat an inherited IRA as their own, allowing for Roth IRA conversions. Non-spouses cannot convert an inherited IRA to a Roth.
About the author
The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.
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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. Schedule a no-obligation consultation with one of our financial advisors today!
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.