What to know about inherited IRAs

May 13, 2024

IRAs are a great tool to save for retirement. With Traditional IRAs, they allow individuals to defer taxes on their contributions and investment earnings until the time of withdrawal. The IRS mandates Required Minimum Distributions (RMDs) beginning at age 73/75 to ensure that individuals with tax-deferred retirement accounts eventually withdraw and pay taxes on their retirement savings. The IRS doesn’t want people to indefinitely postpone paying taxes on these funds.

RMDs are also mandated for Traditional IRAs that an individual inherits. For IRAs inherited after 2019, the SECURE Act mandates that many non-spouse beneficiaries will need to distribute the entire Inherited IRA within 10 years of the original holder’s death. Depending on the size of the inherited IRA and the other forms of income the beneficiary has coming in, these mandated withdrawals can significantly impact a person’s taxable income during the 10-year distribution window.

Let’s break down some of the technical aspects of inherited IRAs and some actions you can take to minimize your tax burden and get the most out of your inheritance.

Categories of Beneficiaries

The SECURE Act established three classifications of beneficiaries based on the individual’s relationship to the original account owner, the beneficiary’s age, and their status as either an individual or nonperson entity. The classifications are Non-Designated beneficiaries, Eligible Designated beneficiaries and Non-Eligible Designated beneficiaries.

Non-Designated Beneficiaries

This category of beneficiary is really a beneficiary that is a non-living entity, such as a charity, a Trust, or a Will. A trust may be exempt from being a not designated beneficiary if it meets certain requirements of a see-through trust. This class of beneficiary must empty the account by the end of the 5th year following the year of the account holder’s death.

Eligible Designated Beneficiaries

To be an EDB, you must be either a:

  • Surviving spouse
  • Minor child less than 18 years of age
  • When a minor child reaches the age of majority, they are no longer considered an EDB, and the 10-year rule relating to withdrawal requirements for a non-eligible designated beneficiary
  • Disabled individual
  • Chronically ill individual
  • Any other individual who is not more than 10 years younger than the deceased account owner

EDBs have some options when it comes to distribution of the money in an inherited IRA. They are a special class of beneficiary that can choose to opt out of the 10-year rule. Instead, they have the option to withdraw the balance of the Inherited IRA over their projected life expectancy, with required minimum distributions calculated annually.

Surviving spouses have yet another withdrawal option at their disposal. The surviving spouse beneficiary can choose to roll the inherited IRA into their own IRA. RMDs would then begin at the surviving spouse’s age 73/75. Since a surviving spouse has several options available to them, and each of these options come with their own tax implications, it’s important to understand what those are and how this money fits with your goals before making a decision.

Non-Eligible Designated Beneficiaries

A non-EDB is any individual who does not fit the above criteria. So if you inherit an IRA from a parent when you are an adult, or you inherit an IRA from someone 10+ years older than you who is not your spouse, you are a non-EDB. One important thing to note is that a minor child of the person who died is an EDB, but a minor grandchild is not.

For non-EDBs, all money in the IRA must be withdrawn by the end of the 10th year following the death of the original owner. If the decedent was subject to RMDs from their IRA, so too will the beneficiary be subject to annual RMDs during that 10-year period.

Beyond that, though, how the money is distributed over those 10 years is up to the recipient. A really helpful exercise is sitting down with your financial advisor to map out likely income during the 10-year period. Then, work to identify possible changes in income, such as:

  • If you are in your peak earning years today but plan to retire at some point during the 10-year window, it can make a lot of sense to hold off on distributions and wait until you are retired.
  • New forms of income beginning, like Pensions, Social Security, or your own RMDs. If you are in the early years of retirement, before your pension/Social Security/your own RMDs begin, you may want to accelerate the inherited IRA distributions in the years prior to those other income streams beginning.

In addition to mapping out likely income during the 10-year period, your financial advisor and tax preparer should also look at your marginal tax rate today vs. where your marginal tax rate might be if the TCJA sunsets on 12/31/2025. For many middle-class earners, the sunset of the TCJA means they will likely have a higher marginal rate in 2026 & beyond vs. the marginal rate that they have today. It may make sense to take withdrawals from an inherited IRA in 2024 and 2025 to fill certain tax brackets. Again, working closely with your financial advisor and tax preparer to determine a plan that makes the most sense for you is a wise idea.

Best practices for surviving spouses

Depending on the age of the person who dies and the age of the surviving spouse, there are a few options for inherited IRAs.

First, if the original owner of the IRA dies before required minimum distributions begin (age 73, or 75 for those born in 1960 or later), the surviving spouse can either roll the money into their own IRA penalty free or keep the inherited IRA as a beneficiary IRA. If the surviving spouse rolls the money into their own IRA, RMDs are based on their own life expectancy, beginning at their age 73/75. If the surviving spouse retains it as an inherited IRA, RMDs follow the decedent’s life expectancy.

Deciding which option is right for you depends on a few things, such as your age at the time of inheritance and the decedent’s age at the time of inheritance. As a general rule of thumb, we recommend leaving the account as an inherited IRA until you turn at least 59.5 years old, as this allows you to withdraw the money penalty free.

Choosing beneficiaries

There are a few considerations when you’re deciding who to leave your IRA to. First, know that the individual with the most flexibility in how they use your IRA will be your surviving spouse, followed by other eligible beneficiaries. Non-eligible beneficiaries have less flexibility because they have to withdraw all the money within 10 years.

If you have included a gift to charities in your estate plan, it can make a lot of sense to fulfill those gifts from your IRA. Unlike individuals who inherit an IRA, any charitable beneficiaries of an IRA will not owe income tax on the IRA dollars received.

Making a plan

I know we say this a lot, but it’s because it’s true – truly the best thing you can do when designating a beneficiary or deciding what to do with an inherited IRA is to speak to a financial advisor! The rules are complicated and there are a lot of factors to consider. We can help walk you through the possible scenarios and decide the right course of action for you, so you can feel confident in your choices.

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