The death of a loved one is a challenging time that takes an emotional toll on surviving family members and friends. It is not a time to be making significant financial decisions, and yet heirs of a deceased estate are inevitably called on to do just that, even when their grief is still raw.
A current cause for concern, which has implications for tax liabilities, estate planning and financial management, is the shifting sands around inherited individual retirement accounts (IRAs), otherwise known as beneficiary IRAs.
When a beneficiary inherits an IRA or employer-sponsored retirement account – be it a 401(k) plan, a Roth or traditional IRA – an inherited IRA must be opened with a bank or brokerage to house the assets (or the allocated portion thereof) bequeathed by the original owner. No new contributions can be made into this account, it is solely to house these inherited assets.
While this might sound simple, don’t be fooled. The devil, as they say, is in the detail – and since 2019 the detail around inherited IRAs has become tangled.
How are Inherited IRA Rules Changing?
In 2019 the Setting Every Community Up for Retirement Enhancement (SECURE) Act changed some of the rules around inherited IRA funds. This applies to the estates of individuals who died on or after January 1, 2020.
The biggest shift was the imposition of the 10-year rule, which means that a beneficiary must ensure that by the end of the 10th anniversary of the original holder’s death all the funds in the account have been withdrawn. Failure to do so, means any funds in the inherited IRA will incur a 50% tax penalty.
- Prior to January 2020 if a non-spouse inherited an IRA they could stretch out withdrawals over their rest of their lives. This was advantageous for tax purposes and to give the funds more time to grow tax free.
- If you inherited an IRA in 2019 and before, this ‘stretch IRA’ characteristics still apply and you will not be affected by the new 10-year rule.
- However, if you inherited after or on January 1, 2020 the inherited IRA must be fully liquidated by the 10th year, which has potential to significantly impact your tax exposure and push you into a higher tax bracket.
But wait, there are exceptions…
There are instances when the 10-year rule does not apply immediately, or at all. They include:
- For minor children of the deceased or for children who haven’t reached the age of majority, the 10-year rule only applies from age 18, after which they have 10 years to withdraw the full amount from the inherited IRA.
- For those who are disabled or chronically ill, can open an inherited IRA and take their distributions over time, including taking a lump-sum withdrawal.
- For people who are a maximum of 10 years younger than the original IRA holder, likely a sibling or a friend from the same generation.
The biggest exception is for spouses.
For instance, a surviving spouse can essentially treat the inherited IRA account as their own by effectively assuming it, or taking full transfer, either into an existing IRA in their name or into a new account. They also have the ability to continue making additional contributions.
As the sole beneficiary of an inherited IRA, spouses can take lump-sum distributions, bearing in mind that this may have tax implications. Or the spouse may choose not to receive any assets in cash. In practice, this means that if you’ve inherited a Roth IRA as a spouse you do not have to take any withdrawals and your Required Minimum Distributions (RMDs) for a traditional IRA only start when you reach 73.
There are other implications for non-spouse heirs, or when the inheritance is split among various beneficiaries. Specifically, no additional contributions can be made and a new IRA must be set up.
Inheritance Tax Implications for Heirs
While, typically, any withdrawals from a retirement account would incur a 10% penalty if the holder is under the age of 59½, this is waved for inherited IRAs. Other than this exception, the Internal Revenue Service (IRS) is sticking to its guns.
The usual rules that apply to traditional IRAs apply to inherited IRAs, for instance that holders are quired to take annual RMDs from either age 73 (born between 1951 and 1959) or 75 (born 1960 or later). The withdrawal amount will be regarded as income and, based on the tax bracket in question, will be subject to income tax.
From tax year 2022, the IRS provided new life expectancy tables to calculate RMDs from retirement accounts. While the withdrawals for the year of the original holder’s death will remain in line with the RMD due to them, thereafter the RMD will depend on the beneficiary’s situation. So, it is important to be well versed in how best to calculate RMDs or to find a professional to assist.
Taking withdrawals from a Roth IRA does not impose RMDs over the life of the account holder, and, notes the IRS: “Most withdrawals of earnings from an inherited Roth IRA account are also tax-free. However, withdrawals of earnings may be subject to income tax if the Roth account is less than five-years old at the time of the withdrawal.”
However, beneficiaries of a Roth IRA since January, 1 2020 still need to ensure they follow the 10-year rule.
Weigh Up the Options with Your Inherited IRA
In July 2023 the IRS said it would not impose a 25% excise tax on heirs who did not take a 2023 distribution from certain inherited IRAs. The view in the industry is that this is a breather before final regulations around this will be issued in 2024.
This gap affords beneficiaries of inherited IRAs time to get their house in order and also to take advantage of a year of tax-free growth. However, this does not mean stick your head in the sand. Now is the perfect time to speak with a professional advisor to determine the right plan of action for you and your inheritance.
When it comes to people-centric solutions to complex choices around inherited IRAs, retirement decision making and financial planning, Mottet Wealth, one of Kansas City’s leading investment and wealth management firms, is here to guide you through this difficult time.
Please do get in touch to book a face-to-face or online consultation. Together we’ll bring all the threads of your financial situation together, carefully consider your tax liabilities, RMDs requirements and how to spread out IRA distributions, as well as discussing potential withdrawals to fund big-ticket purchases like home purchases, and your future legacy wishes.