Those who have recently inherited an IRA or other retirement plan have probably discovered that there are multiple distribution options, each with its own pros and cons. Couple this discovery with the complex IRS rules and onerous paperwork requirements and the process of transferring and distributing the inherited assets may seem overwhelming. To make the process a little clearer, let’s drill down to the basic rules surrounding inherited IRAs which may give a better idea of the choices available.
What happens when the original IRA owner passes away?
When an IRA owner dies, his or her retirement assets pass on to the named beneficiary. If no beneficiary is named, the assets generally pass on to the owner’s estate, or to the spouse if the IRA plan allows. The distribution options available to a beneficiary depend on the following factors:
• What is the relationship between the deceased and the named beneficiary? For example, is the beneficiary a spouse, non-spouse (sibling, child, friend, etc.), or an entity such as a charity or estate?
• Is the inherited account a Traditional or Roth IRA?
• If the inherited IRA is a Traditional IRA, did the original owner pass away before or after reaching age 70 ½?
Options for spouse
Spouse beneficiaries generally have the simplest distribution options. Spouse beneficiaries can either 1) roll the inherited IRA into an IRA of their own, or 2) transfer the assets into a Beneficiary IRA.
What are the options if a spouse inherits a spouse’s Traditional IRA?
If a spouse is inheriting a Traditional IRA, and chooses to roll the inherited IRA into an IRA of their own, they can withdraw funds without a penalty after age 59 ½. In addition, they will not be required to withdraw any funds until they reach age 70 ½. Rolling the inherited IRA into an IRA of their own may be the best option for those who won’t need to withdraw the funds until after they reach age 59 ½.
However, if the spouse needs to withdraw the inherited IRA funds for any reason before reaching age 59 ½, transferring the assets into a Beneficiary IRA may be a better option. This will give the flexibility to take withdrawals without incurring a 10% penalty. Keep in mind, however, that distributions are still subject to taxes. In addition, the spouse can delay taking mandatory distributions until they or the original owner would have reached age 70 ½ (whichever is later). One additional rule to note: If the original account owner was over age 70 ½, and the surviving spouse decides to transfer the assets into a Beneficiary IRA, they must first withdraw any Required Minimum Distributions (RMDs) that the original owner did not take. Thereafter, the spouse can begin withdrawing annual distributions over the longer of their life expectancy or the original owner’s remaining single life expectancy.
What are the options if a spouse inherits a spouse’s Roth IRA?
As a spouse beneficiary of a Roth IRA, they may roll the inherited Roth IRA into a Roth IRA of their own, they are able to withdraw contributions the original owner made both penalty and tax-free at any time. In addition, once the Roth IRA or the original owner’s Roth IRA has been open for at least 5 years and the beneficiary has reached age 59 ½, they will be able to withdraw the account’s investment earnings tax and penalty free. However, if they need to withdraw funds from the Roth IRA for any reason before reaching age 59 ½, a better option is to transfer the assets into a Beneficiary Roth IRA. By doing this, all distributions from the Beneficiary Roth IRA will be penalty free. In addition, if the original Roth IRA was held for at least 5 years, distributions will also be tax free.
What are the options if a person other than the spouse or representing an entity inherits a Traditional or Roth IRA?
If the beneficiary is a non-spouse or entity, they only have one option available regardless of whether they inherited a Traditional or Roth IRA. The inherited assets must be transferred into a Beneficiary IRA which is commonly referred to as a “stretch IRA.” They do not have the option of rolling over the assets into their own IRA. Furthermore, they are required to take distributions, either by removing an annual RMD based on their own life expectancy or by distributing the entire inherited account within five years. If an entity is inheriting an IRA, then all of the inherited assets must be distributed within five years, unless the original owner was over age 70 ½ and subject to RMDs. In this case, an entity can distribute the IRA over the original owner’s life expectancy. Also remember, if the original account owner was over age 70 ½, any RMDs that the original owner did not take must be withdrawn first. Whether you are a person other than the spouse or are representing an entity that is receiving inherited assets, failure to withdraw any required distributions may result in a 50% penalty on the undistributed amount.
There are many rules surrounding the distribution options available to IRA beneficiaries. But there are a few things beneficiaries can do to narrow down the choices:
• Step 1: Decide what type of IRA to open to receive the inherited funds. If the beneficiary is the spouse, they may decide if they will need to take withdrawals immediately, or any time prior to reaching age 59 ½. If so, they may consider opening a Beneficiary IRA. If not, they may consider rolling the funds into their own IRA. Beneficiaries other than spouses must open a Beneficiary IRA.
• Step 2: Know when to take withdrawals. If the beneficiary is the spouse, they generally aren’t required to take distributions before age 70 ½. Persons other than spouses are generally required to take a distribution annually. Entities are required to distribute inherited assets in 5 years. Keep in mind that beneficiaries can always withdraw more than any annual required distribution.
• Step 3: Understand the possible tax implications. Generally, distributions from an inherited Traditional or Roth IRA are not subject to the 10% withdrawal penalty. Distributions from an inherited Traditional IRA may be subject to taxes, while withdrawals from an inherited Roth IRA are generally tax-free if the original Roth IRA was held for 5 years.
• Step 4: Remember to take a withdrawal if required. If minimum withdrawals are required, and the beneficiary fails to do so, they may be subject to a penalty equal to 50% of the shortfall.