Understanding and successfully following the inherited IRA rules can be a bit confusing, but it doesn’t take away from the fact that it’s vitally important to get it right. As there is a 50% penalty of the amount you should have distributed if you don’t take the proper RMD’s (Required Minimum Distributions).
Never forget: The IRS wants its money and the IRS gets paid when you distribute money from an IRA account.
As a result of the SECURE Act that was passed in late 2019, there are now essentially two sets of rules (and some additional sub rules) for inherited IRAs.
How do you determine which set of rules to follow depends on two things:
- When did the original account owner die, and
- Who is listed as the beneficiary of the account.
If the original IRA account holder passed away in 2020 or later
If the IRA owner died in 2020 or later, we first must determine whether the beneficiary is an “eligible beneficiary” or not.
Eligible beneficiaries include:
- The surviving spouse of the original account owner,
- A minor child of the original account owner,
- Anybody who is disabled or chronically ill, or
- Any designated beneficiary who is not more than 10 years younger than the original account owner.
If the beneficiary is an “eligible beneficiary,” then the more favorable “old” rules apply – go to the section that begins with “Eligible beneficiaries and deaths that took place in 2019 or earlier” below. If the beneficiary isn’t considered an eligible beneficiary, then the “New” Inherited IRA Rule applies – see below.
The “New” Inherited IRA Rule
If the beneficiary is not an “eligible beneficiary” from above, the new rule applies. What’s the new rule say?
It says that the account must be completely distributed within 10 years of the original owner’s death.
The distributions do not, however, require that they be taken evenly over those 10 years. For example, if you wanted, you could take no distributions for the first 9 years, then distribute everything in year 10. However, the account must be fully distributed by 12/31 of the 10th anniversary year of the original owner’s death.
Eligible beneficiaries and deaths that took place in 2019 or earlier
The “old rules” discussed in the remainder of this article apply in situations in which either:
- The IRA owner died in 2019 or earlier, or
- The beneficiary is an “eligible beneficiary” as described above, and therefore able to use the more favorable old rules.
Under the “old rules,” there are still actually two sets of rules: one set of rules that applies if the deceased owner was your spouse, and another set for any other designated beneficiary.
With this, the rules are different depending on the relationship to the original account holder:
- Spouse Beneficiary
- Non-spouse beneficiary
- Multiple beneficiaries
1. Inherited IRA: Spouse Beneficiary
As a spouse beneficiary, you have two primary options:
- Do a spousal rollover — rolling the account into your own IRA.
- Continue to own the account as a beneficiary, or
- Convert to a Roth IRA account (taxes will be due at the time of conversion).
Note: There is no deadline on a spousal rollover. Should you want to, you can own the account as a spousal beneficiary for several years, then elect to do a spousal rollover.
If you do a spousal rollover, from that point forward it’s just a normal IRA (i.e., it’s just like any other IRA that was yours to begin with), so all the normal IRA rules apply, whether Roth or traditional.
If you continue to own the account as a spousal beneficiary, the rules will be similar to normal IRA rules, but with a few important exceptions.
No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)
Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the ‘5-year rule’ will be subject to income tax (though not the 10% penalty).
Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he/she died, but he/she had not yet taken it, you’re required to take it for him/her, calculated in the same way it would be if he/she were still alive.)
Your RMD from the account will be calculated each year based on your own remaining life expectancy from the ‘Single Life’ table in IRS Publication 590-B.
2. Inherited IRA: Non-Spouse Beneficiary
When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.
No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)
Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)
Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a required minimum distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)
The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**
For example, imagine that your father passed away in 2018 at age 65, leaving you his entire IRA. For 2018 (the year of death), you have no RMD. On your birthday in 2019, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2019 would have been equal to the account balance as of 12/31/2018, divided by 53.3.
For 2020, if it weren’t for the CARES Act eliminating RMDs for 2020, your RMD would have been equal to the account balance at the end of 2019, divided by 52.3. (But because of the CARES Act, the RMD for 2020 would be zero.) In 2021, the RMD will be the 12/31/2020 balance, divided by 51.3.
Important exception: if you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.
Successor Beneficiary RMDs
If a beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.
If the original account owner died in 2020 or later and the original beneficiary (i.e., the first person to inherit the IRA) was a “non-eligible” beneficiary, then the successor beneficiary will have to keep using the same distribution schedule. That is, the successor beneficiary will have to distribute the account within 10 years of the original owner’s death.
Conversely, if the original account owner died before 2019 and/or the original beneficiary was an “eligible” beneficiary, then the successor beneficiary will have to distribute the account over 10 years, but it’s a new 10-year period, beginning with the date of the original beneficiary’s death (rather than beginning with the date of the original owner’s death).
Tips for Non-Spouse Beneficiaries
- When you retitle the account, be sure to include both your name and the name of the original owner.
- Name new beneficiaries for the account ASAP.
- If you decide to move the account to another custodian (to Fidelity from Charles Schwab, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you had distributed the entire account.
3. Inherited IRA: Multiple Beneficiaries
If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.
However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size.
This is a good thing, because it means that:
- A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
- Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.
Note: If the original owner dies in 2020 or later and at least one beneficiary is a “non-eligible beneficiary” (per the definition from the beginning in this article), then the whole account will have to be distributed within 10 years, unless the IRA agreement has a provision that immediately divides the IRA into separate IRAs for each beneficiary.
To split an inherited IRA into separate inherited IRAs:
- Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
- Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
- Change the SSN on each account to be that of the applicable beneficiary.
Some parting thoughts
When you inherit an IRA, it is imperative that you take the time to learn the applicable rules before doing anything. Don’t move the money or make any changes until you understand all of the potential implications because simple administrative mistakes can be very costly.
-Paul R. Rossi, CFA