Last week, we talked about one of the more common results of the wealth transfer process after the passing of the owner of a 401(k), IRA, or another similar tax-advantaged account. This being the creation of an inherited IRA. If you aren’t sure what an inherited (or beneficiary) IRA is and where it factors into a well-designed estate plan, please go back and give our previous article a quick read.
This week, we’re getting into the nitty gritty of inherited IRAs so as to give you a better understanding of how they work. This information is relevant to those who own tax-advantaged accounts that could become an inherited IRA upon passing and may be wondering how their beneficiary(ies) may be allowed to treat that money. Too, the information here will help those who’ve inherited an IRA to ensure they’re making the most of it while not facing unwanted tax implications.
To do so, we’ll answer the following questions:
- What are my options when inheriting an IRA?
- What are the tax implications when I inherit an IRA?
- Can I rollover the money into my existing IRA?
- What happens when I withdraw funds from my inherited IRA?
3 Details You Need to Know About Your Inherited IRA First
Before you can know how your inherited IRA works, you need to know three important details:
- What kind of beneficiary you are. Not all relationships are treated as equal in the eyes of the tax man when it comes to inheriting funds marked for retirement.
- If you’re inheriting a traditional or a Roth IRA. When taking withdrawals from these types of accounts, the tax implications are very different.
- If the original owner of the account had reached their required beginning date (RBD)–the date that required minimum distributions (RMDs) begin.
Below, we’ll detail what is and isn’t allowed for each of these respective situations during (1). The initial phase of inheriting money from a retirement investment account and (2). The withdrawal phase of the inherited IRA.
Inherited IRA Rules for Spousal Beneficiaries
When it comes to inheriting these accounts, spouses have the greatest flexibility, both during the initial phase of the inheritance and throughout the life of those funds. Here are their initial options when inheriting a retirement account.
The Initial Phase
Upon inheriting funds from an IRA, a spouse has three primary options (assuming a full, immediate withdrawal doesn’t take place):
- Assume ownership of the IRA, placing it in your name and treating it as your own IRA. This means this account falls under the rules for a traditional IRA or Roth, and is not considered an inherited IRA
- Roll the funds from the original IRA into a pre-existing IRA of your own. This has to be done within 60 days of the original account owner’s death
- Setup a new inherited IRA and transfer the funds there. Options 1 & 2 are the much more advantageous options, for reasons that will be made clear in section below detailing withdrawal options for this inheritance.
The Withdrawal Phase
This phase is considering how the funds will be distributed to you and should be influenced by a mix of your own preference, careful tax planning, and IRS rules. Here is how a spousal beneficiary can decide to receive the inherited retirement funds:
- If you’ve chosen options one or two above–assuming ownership of a decedent’s IRA or rolling those IRA funds into a pre-existing IRA of your own, then the withdrawal rules for those funds follow the normal rules for a traditional IRA, which are:
- Withdrawals are taxed as ordinary income
- Withdrawals taken before your age 59 ½ incur an additional 10% penalty
- RMDs must be taken upon reaching age 73 (this will change to age 75 in 2033)
- If you’ve gone with the generally less ideal option three above–opening up an inherited IRA–you’ll have one option outside of a full, immediate withdrawal”:
- The 10-year method. This is essentially treating the funds like you were not a spousal beneficiary. You must withdraw the funds in full from the inherited IRA within 10 years of the year after the decedent died. You can take withdrawals in any pattern throughout this period, as long as the account is fully drained by the end of the 10th year. There is one caveat to this–as of 2025, if the original account owner already hit their RBD and thus began RMDs, then the beneficiary must continue RMDs throughout this 10 year period.
- You can also decide to receive the funds from the original IRA immediately in full. These funds will be subject to ordinary income tax, and could very well cause a significant portion to be taxed at higher income tax brackets than you’re used to. These funds will not be subject to a 10% penalty, even if you are under the age of 59 ½. This method has two main disadvantages:
- As mentioned, these funds will be subject to income tax–some of which possibly at a higher bracket than you’re used. Even if you need some of these funds, it may be better to take from a source that won’t add to your tax burden.
- If you withdraw these funds immediately, you’re missing out on the pre-tax investment growth potential of these funds. Again why it may be best to dip into another source of funds that won’t add to your tax burden.
A couple quick caveats to the above information occur when it comes to Roth IRAs. Withdrawals from Roths are not subject to income tax, however they are subject to the 10% early withdrawal penalty if taken before age 59 ½, unless the distributions are taken according to the life expectancy method or 10-year method as described above. This means that inheriting funds from a Roth, even a full lump sum withdrawal won’t add to your tax burden. However, it is important to note that if the Roth has been open for less than five years, earnings (interest growth) on the account are taxable.
Inherited IRA Rules for Non-Spousal Beneficiaries
Non-spousal beneficiaries, or more officially known here as Designated Beneficiaries, have to be more careful so as to know fully the rules of their inherited money. Otherwise, they could be facing unwanted penalties or could fail to consider how the withdrawal rules could affect their overall tax burden. They have less flexibility and, in that sense, the rules are simpler for them.
The Initial Phase
Assuming a full, immediate withdrawal doesn’t take place, a non-spousal beneficiary has only the option to set up a new inherited IRA in their name.
The Withdrawal Phase
Again, less flexibility means things are simplified. For withdrawals, there are only two options:
- The 10-year method. You must withdraw the funds in full from the inherited IRA within 10 years of the year after the decedent died. You can take withdrawals in any pattern throughout this period, as long as the account is fully drained by the end of the 10th year. The only caveat to this is takes effect in 2025 and occurs if the original account owner already hit their age 73 before death. In this case, during the 10 year period, RMDs will have to be continued. All distributions, whether RMDs or withdrawals of your choosing during the 10 year period are taxed as ordinary income. You will not, however, incur a 10% early withdrawal penalty on these distributions even if you’re under age 59 ½.
- Assuming you don’t open an inherited IRA and rather elect to take a full, immediate withdrawal of these funds, then the same rules apply for both spousal and non-spousal beneficiaries (see option 3 in the previous section).
Again, if the inherited account is a Roth, then those withdrawals won’t be subject to income tax. They are, however, subject to the 10% early withdrawal penalty if taken before age 59 ½, unless the distributions are taken according to the 10-year method as described above. Another important note to repeat: if the Roth has been open for less than five years, earnings (interest growth) on the account are taxable.
Three Important Final Considerations
The first consideration–as with all tax laws in this nation, almost nothing is simple. To each caveat there is often another caveat. Such is the same here. One further caveat is for the above information regarding non-spousal beneficiaries. This is as it relates to what’s known as Eligible Designated Beneficiaries, which are a less common set of individuals for whom there are somewhat different allowances for these inheritances, and of whom we haven’t discussed here. This set of individuals falls into one of the below categories:
- Minor children of the original IRA owner who passed away
- Permanently disabled or chronically ill individuals
- Individuals who are less than 10 years younger than the passed account owner
A second consideration–a major way that inherited IRAs differ from traditional IRAs is when it comes to contributions. Traditional IRAs allow for an annual, tax-deductible contribution. Inherited IRAs, however, do not allow for this contribution.
Thirdly and finally, inherited IRAs are best viewed as temporary. Whereas with a traditional IRA, you can wait until you hit RBD age 73 before needing to take withdrawals and a Roth IRA where you don’t have to take withdrawals at all, with an inherited IRA, you always have to eventually take withdrawals. This even applies to funds inherited from a Roth.
Will Your Wealth Transfer Be According to Your Wishes?
Are you looking to get your estate plan in order so as to have control over the transfer of your wealth upon passing? Have you or may you soon inherit a retirement investment account and want to ensure that you don’t face unwanted tax implications due to not knowing all the rules of an inherited IRA?
We hope this article has given you a place to start. However, as you can see, an inherited IRA should be taken into consideration not as a sole entity, but rather as one part of many of a tax-optimized retirement plan. If you’d like to know how to treat an inherited IRA as part of a larger plan specific to your unique financial situation, please click the button below to schedule a complimentary 15 minute strategy session with one of our advisors.
