Inherited IRA: Everything a Beneficiary Should Know
An inherited IRA is an account used to transfer assets a beneficiary inherited from the retirement account of a person who passed away. After inheriting an IRA, you may find yourself confused about the distribution and taxation rules. That’s why we’ve prepared a guide in which we explain how all of this works.
What Is an Inherited IRA?
First, let’s define the IRA and inherited IRA. IRA, which stands for Individual Retirement Arrangement, is a type of investment account that helps individuals save up for retirement. There are several types of IRAs, some of which allow future retirees to invest tax-free, while others work on a tax-deferred basis.
IRA types are:
- Roth IRA
- Traditional IRA
- Payroll Deduction IRA
- SIMPLE IRA
For example, traditional IRA allows account holders to withdraw money without any penalties once they turn 59½. The contributions are tax-deductible. However, taxes apply to the money taken out of the account.
On the other hand, with Roth IRAs, tax is not deductible initially, but the funds can be withdrawn tax-free, provided that the account is at least five years old, and the account owner is at least 59½ years of age.
An inherited IRA, also referred to as a beneficiary IRA, is an account that is opened for the beneficiary after the original retirement account owner passes away. The beneficiary is then free to withdraw the inheritance.
You should keep in mind that the assets may be taxed differently according to the retirement account type, and that early withdrawal fees may apply. We’ll discuss this in more detail in the following sections.
Inherited IRA Distribution Rules
The inherited IRA rules changed on January 1st, 2020, with the introduction of the SECURE Act. This act imposes a ten-year rule on non-eligible designated beneficiaries. Before the Act, anyone could stretch out their inherited IRA distributions over their life expectancy.
What this means is that if you inherit an IRA from anyone who was not your spouse or other eligible designated beneficiary (EDB), you’re required to empty the account within a ten-year period. Before the rule, beneficiaries could take smaller distributions and stretch them out for decades, thus deterring taxes as their accounts grew.
The EDBs exempt from this rule include:
- Chronically ill or disabled
- Minor children
- Individuals who are less than ten years younger than the late IRA account owner
- Certain trusts
The rule applies if the IRA owner’s year of death is 2020 or later. Initially, when the Act was first introduced, there were no required minimum distributions (RMDs). However, they have been brought back by the IRS, and beginning in 2023, anyone who fails to withdraw the required amount on an annual basis will be subject to a 50% penalty taxation.
Eligible beneficiaries don’t have to take out RMDs until they turn 72, according to the new inherited IRA distribution rules. The age requirement was 70½ before.
Furthermore, spouses can assume the account, which means that the IRS will treat it as if it was theirs to begin with. This allows them to proceed with making contributions, and the RMDs are recalculated to new life expectancy.
Inherited IRA Taxation Rules and Withdrawal Strategies
Whether you’ll have to pay tax on your inherited IRA depends on the type of IRA you’re a beneficiary of. In the case of Roth IRA, the original account owner already paid taxes, so you won’t be subject to any income tax, as long as the original IRA owner funded the account at least five years before their death.
That’s not the case with traditional IRA, because you have to pay income taxes when withdrawing the money. On the bright side, there is no early withdrawal penalty regardless of the beneficiary’s age.
The SECURE Act has altered withdrawal strategies of those who don’t belong to the eligible designated beneficiary category. Nevertheless, it’s still advisable to avoid cashing out an inherited IRA in full right away. Instead, you can take the money out in even installments over the ten-year period, or wait until the end of that period and withdraw everything at once.
The Rules for Multiple Beneficiaries
When there are multiple beneficiaries of an inherited IRA account, the rules can get a little more confusing. Let’s take a case where there are multiple beneficiaries, one of whom is an EDB while the other is not, as an example.
For EDB to surpass the SECURE Act rule and stretch out the inheritance over their life expectancy, there needs to be a separate account created for them. If not, they will have to empty the account within ten years upon the original IRA owner’s death.
On the other hand, if all beneficiaries are EDBs and the account is not separated, the life expectancy of the oldest beneficiary is taken into account. If the beneficiaries wish to have separate accounts, they have to finish the process by December 31st, the year after the original account owner’s death.
The Rules for Multiple Inherited IRAs
The rules regarding multiple IRAs vary according to who the original account owners are and what the account types are. For instance, if you inherit two traditional IRAs from the same person, you can combine them because the RMDs are calculated the same way. In the case where there are different account owners, the accounts can’t be combined.
The Bottom Line
All in all, handling your IRA inheritance doesn’t have to be as complex as it may first seem. Once you understand the distribution and taxation rules, you can employ simple strategies when withdrawing your inherited IRA funds to avoid paying a large sum in tax. The general rule of thumb is not to withdraw the funds right away.
What is the difference between an inherited IRA and a beneficiary IRA?
There is no difference between an inherited IRA and a beneficiary IRA. The two terms are used synonymously to denote a retirement account someone inherits upon an individual’s passing.
What is the best thing to do with an inherited IRA?
Inherited IRAs are handled differently based on whether you’re a surviving spouse or non-spouse beneficiary. As the spouse of the person who died, you can spread out the IRA assets over the rest of your life.
On the other hand, non-spouse beneficiaries have to empty the inherited account within a ten-year period. In that case, it’s best to either withdraw smaller amounts periodically or take everything out at once toward the end of that period.
What is the five-year rule for an inherited IRA?
The five-year rule for inherited IRAs applies to IRA beneficiaries who aren’t taking life expectancy withdrawals. This means that they would have to take out the entire amount by the end of a five-year period after the death of the original account holder.
Another five-year rule for inherited IRAs has to do with roth IRAs. Those who inherit this type of IRA are exempt from paying income taxes if they wait at least five years to withdraw the funds.
How do I avoid paying taxes on an inherited IRA?
You may not be able to avoid paying taxes on your IRA inheritance, but there are strategies you can use to minimize them. For example, if you’re a non-eligible designated beneficiary, you’ll have to empty the account by the end of a ten-year period. In that case, it’s advisable to either wait until the period almost ends to withdraw the full amount or to take out small amounts of money regularly.
Can I cash out an inherited IRA at any time?
When it’s best to cash out an inherited IRA depends on the IRA account type. Even though there is no rule that says you can’t withdraw your inheritance at any time, you should be smart about it because of tax rules and penalties for early withdrawal.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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