What is an inherited IRA?
An inherited IRA is an account that is opened when a person inherits an IRA or employer-sponsored retirement plan after the death of the original owner. The person who inherits the Individual Retirement Account (IRA) (beneficiary) can be anyone – a spouse, parent, or an unrelated party or entity (estate or trust). However, the rules on how to manage an inherited IRA differ for spouses and non-spouses.
An inherited IRA is also called a “beneficiary IRA”. A lot of best brokers for IRAs provide support in resolving those issues related to inheriting IRA assets, tax issues, and maintaining retirement account status.
The tax laws surrounding inherited IRAs are quite complicated, and they have become even more so with the Preparing Every Community for Retirement Enhancement (SECURE) Act of 2019, which made significant regulatory changes, mainly for heirs other than spouses.
Key points to remember
- An inherited IRA, also known as a beneficiary IRA, is an account that is opened when a person inherits an employer-sponsored IRA or retirement plan after the death of the original owner.
- Additional contributions cannot be made to an inherited IRA.
- The rules vary for joint and non-joint beneficiaries of inherited IRAs.
- The SECURE Act required non-spouse beneficiaries to empty inherited IRAs within a decade.
Understanding Legacy IRA
A beneficiary can open an inherited IRA using proceeds from any type of IRA, including traditional, Roth, rollover, SEP, and SIMPLE IRAs. Generally, assets held in the deceased person’s IRA should be transferred to a new inherited IRA in the beneficiary’s name.
This transfer must be made even if a lump sum distribution is planned. Additional contributions cannot be made to an inherited IRA.
The Internal Revenue Service provides guidelines for inheriting IRA beneficiaries. IRS Forms 1099-R and 5498 are required to report inherited IRAs and their distributions for tax purposes.
Legacy IRAs are treated the same whether they are Traditional IRAs or Roth IRAs. The tax treatment of withdrawals varies depending on the type of IRA (funded with pre-tax dollars, like the traditional type, or after-tax dollars, like the Roth).
Inherited IRAs: Rules for Spouses
Spouses have more flexibility in how to manage an inherited IRA. For one thing, they can roll over the IRA, or part of the IRA, into their own existing Individual Retirement Accounts; the great advantage of this is the possibility of differing minimum required distributions (RMD) funds up to age 72.
RMDs previously started at 70½, but the age was raised to 72 after the December 2019 passage of the SECURE (Setting Every Community Up For Retirement Enhancement) Act.
They have 60 days from receiving a distribution to roll it over to their own IRAs as long as the distribution is not a required minimum distribution.
Joint heirs can also create a separate inherited IRA account, as described above. How they handle this IRA depends on the age of the deceased account holder.
If the original owner had already started receiving RMDs at the time of death, the beneficiary spouse must continue to receive the distributions as calculated or submit a new schedule based on their own life expectancy. If the owner has not yet committed to an RMD schedule or has not reached their start date required (RBD) – the age at which they were to start RMDs – the IRA beneficiary has a five-year window to withdraw the funds, which would then be subject to income tax.
Inherited IRAs: rules for non-spouses
Non-spouse beneficiaries cannot treat an inherited IRA as their own. That is, they cannot make additional contributions to the account, or transfer funds into an existing IRA account they have in their own name. Non-spouses cannot leave assets in the original IRA. They must create a new Legacy IRA account unless they want to distribute the assets immediately via a lump sum payment.
It is in the area of distributions that the SECURE law most drastically affects non-spouse heirs of IRAs. Previously, these beneficiaries could manage RMDs much like inheriting spouses could; in particular, they could recalculate them based on their own life expectancy, which often significantly lowered the annual amount that had to be withdrawn and the tax due on them (in the case of traditional IRAs).
Those who inherit Roth IRAs are required to take distributions (unlike original account holders), but the funds remain tax-free and also free from any early withdrawal penalties, even if the beneficiary is under 59½.
Not anymore. The SECURE Act states that, for accounts inherited after December 31, 2019, non-spouse beneficiaries must generally withdraw the account within 10 years of the death of the original owner. Certain heirs are exempt: those whose age is less than ten years from that of the deceased, disabled or chronically ill persons, or minor children. However, these minors must be direct descendants (no grandchildren, in other words), and, once they reach the age of majority, the 10-year rule applies to them as well. . There is no particular timetable for withdrawals; they can be taken annually or all at once.
For beneficiaries in these categories and those already in possession of inherited IRAs, the old distribution rules and schedules remain in effect.
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