Avoiding Costly Blunders When Inheriting an Individual Retirement Account (IRA)
Navigating Inherited IRAs: A Comprehensive Guide
Inheriting an Individual Retirement Account (IRA) can be a complex process, requiring careful consideration and professional advice to ensure compliance and minimise tax implications. Here's a breakdown of the key points to consider when dealing with an inherited IRA.
What is an Inherited IRA?
An inherited IRA is created when an IRA is passed on to a spouse, family member, or loved one after the account holder's death. The type of IRA (Traditional or Roth) will determine the taxation of distributions and the distribution options available to the beneficiary.
Traditional IRA
Distributions from a Traditional IRA to the beneficiary are taxed as ordinary income at the time of withdrawal. The distribution deadline varies, depending on the beneficiary's life expectancy before the SECURE Act of 2019. For non-spouse beneficiaries, the entire account must be distributed within 10 years of the original owner’s death (new rule).
Roth IRA
Distributions from a Roth IRA are generally tax-free if the account was open for at least five years before the original owner’s death. The distribution deadline for a Roth IRA is the same as for a Traditional IRA, but without the SECURE Act's 10-year rule restrictions.
Spouse Beneficiaries
Spouse beneficiaries have the most flexibility, as they can treat the inherited IRA as their own or roll it over into an IRA in their name, allowing more flexible distribution timing.
Non-Spouse Beneficiaries
For non-spouse beneficiaries (such as children or siblings), the options are more limited. They generally cannot treat the IRA as their own and must follow special rules, including the SECURE Act provisions. Non-spouse beneficiaries must ensure the inherited Roth IRA is emptied within 10 years of the original owner’s death.
The SECURE Act of 2019
The SECURE Act significantly changed required distributions for non-spousal beneficiaries. It eliminated the “stretch IRA” option for most non-spousal beneficiaries, which previously allowed distributions over the beneficiary’s lifetime. Instead, non-spousal beneficiaries must now fully distribute the entire inherited IRA within 10 years of the original owner’s death.
Impact on Trusts and Tax Planning
The SECURE Act affects how inherited IRAs held in trusts are managed. Conduit trusts require distributions to be passed directly to beneficiaries, potentially causing large taxable income in a short time. Accumulation trusts can retain IRA distributions but still must comply with the 10-year full distribution requirement, potentially incurring trust-level taxes.
Proper tax and estate planning can mitigate some tax burdens, potentially involving charitable remainder trusts or consideration of Roth conversions.
Inheriting an IRA requires mindfulness, opening the proper account, making tax-smart withdrawals, and seeking help when needed to avoid costly mistakes.
[1] Investopedia. (2021). Inherited IRA. [online] Available at: https://www.investopedia.com/terms/i/inheritedira.asp
[2] Forbes Advisor. (2021). Inherited IRA: Everything You Need To Know. [online] Available at: https://www.forbes.com/advisor/investing/inherited-ira/
[3] Fidelity. (2021). Inheriting a Roth IRA. [online] Available at: https://www.fidelity.com/learning-center/personal-finance/estate-planning/inheriting-roth-ira
[4] Kiplinger. (2021). The SECURE Act: What You Need to Know. [online] Available at: https://www.kiplinger.com/slideshow/retirement/T041-S001-the-secure-act-what-you-need-to-know/index.html
[5] The Balance. (2021). Inherited IRA Rules: What You Need to Know. [online] Available at: https://www.thebalance.com/inherited-ira-rules-and-regulations-4166112
Managing an inherited IRA, whether Traditional or Roth, necessitates personal-finance strategies, particularly when it comes to understanding tax implications and distribution deadlines. For non-spouse beneficiaries, adhering to the SECURE Act's 10-year distribution rule and allocating funds wisely in trusts is crucial for proper tax and estate planning.
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