Understanding the choices for inherited IRAs
E*TRADE from Morgan Stanley02/28/19
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 will be paid to the default beneficiaries under the terms of the IRA document. 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 RMD age1?
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 tax after age 59 ½. In addition, they will not be required to withdraw any funds until they reach RMD Age. 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 tax. Keep in mind, however, that distributions are still subject to ordinary income taxes. In addition, if the spouse transfers the assets into a Beneficiary IRA, the spouse can delay taking mandatory distributions until they or the original owner would have reached RMD Age. One additional rule to note: If the original account owner died on or after April 1st of the year following the year in which the IRA owner reached RMD Age, they must withdraw any Required Minimum Distributions (RMDs) that the original owner did not take. Thereafter, if the spouse transfers the assets into a Beneficiary IRA, 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 tax and income tax free at any time. In addition, once the Roth IRA or the original owner’s Roth IRA has satisfied the 5 year holding period requirement and the beneficiary has reached age 59 ½, they will be able to withdraw the account’s investment earnings income tax and penalty tax free. However, if they need to withdraw funds from the Roth IRA for any reason before reaching age 59 ½, a better option may be to transfer the assets into a Beneficiary Roth IRA. By doing this, all distributions from the Beneficiary Roth IRA will be penalty tax free. In addition, if the original Roth IRA satisfied the 5 year holding period requirement, distributions will also be income tax free.
What are the options if a person other than the spouse inherits a Traditional or Roth IRA?
If the beneficiary is a non-spouse or entity, they only have one option available (other than a taxable distribution) regardless of whether they inherited a Traditional or Roth IRA. The inherited assets can 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 satisfy the RMD rules, which depending on the specific facts and circumstances, may require them to take annual distributions based on the applicable life expectancy or withdraw the entire balance of the IRA by the end of the 5th year or 10th year, as applicable, following the year of the IRA owner's death. If an entity is inheriting an IRA, then all of the inherited assets must be distributed within five years, unless the original owner died on or after April 1st of the year following the year in which the they reached RMD Age. In this case, an entity can distribute the IRA over the original owner’s life expectancy. Also remember, if the original account owner died on or after April 1st of the year following the year in which the IRA owner reached RMD Age, any RMDs that the original owner did not take must be withdrawn first. Failure to withdraw any required distributions may result in a 25% (or 50% for tax year before 2023) 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:
1 RMD Age is age 70 ½ for individuals born before July 1, 1949; age 72 for individuals born after June 30, 1949, but before 1951; age 73 for individuals born after 1950, but before 1960; or age 75 for all other individuals (note, there appears to be a drafting error in the statutory language, making it unclear when age 75 starts to apply in lieu of age 73, but it appears it was intended to apply to individuals born after 1959).
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.
Know when to take withdrawals. If the beneficiary is the spouse, they generally aren’t required to take distributions before RMD Age. Persons other than spouses are generally required to either take a distribution annually (reducing the balance to zero over a specified period of time) or withdraw the entire balance by the end of a specified period (e.g., by the end of the 10th year following the year of the IRA owner's death). Entities are required to distribute inherited assets in 5 years or receive annual distribution over the remaining life expectancy of the deceased IRA owner, depending on when the IRA owner died. Keep in mind that beneficiaries can always withdraw more than any annual required distribution (if applicable).
Understand the possible tax implications. Generally, distributions from an inherited Traditional or Roth IRA are not subject to the 10% withdrawal penalty tax. 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 satisfied the 5 year holding period requirement.
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 tax equal to 25% (or 50% for tax years before 2023) of the shortfall.