What you need to know if you inherit an individual retirement account
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As baby boomers age into their 70s and 80s, it is estimated that more than $84 trillion will pass down through inheritances to millennial and Gen X heirs before 2045.
As children, grandchildren and other relatives of “boomers,” many physicians may benefit from these inheritances. One of the most common assets to inherit is an individual retirement account (IRA), especially those rolled over from prior retirement plans. While inheriting an IRA certainly can be a significant financial windfall, it also comes with a set of rules and regulations that beneficiaries must navigate. Understanding these rules is crucial to maximizing the benefits of an inherited IRA, while avoiding costly mistakes and penalties. In this article, we will explore the ins and outs of inherited IRAs and the essential rules that beneficiaries should know.
Types of inherited IRAs
An inherited IRA is an individual retirement account that is passed down to a beneficiary after the original account holder's death. This beneficiary can be a spouse, a child, a grandchild or any other person or entity designated by the original account holder. Inherited IRAs come with tax advantages and provide a way for the beneficiary to continue growing the funds within the account.
There are two main types of inherited IRAs, and the rules governing each can vary significantly:
Traditional inherited IRA: This type of inherited IRA is typically created when the original account holder had a traditional IRA, including a rollover IRA emanating from former qualified retirement plan(s). When you inherit a traditional inherited IRA, you will generally need to pay taxes on the distributions you take from the account, just as the original account holder would have.
Roth inherited IRA: If the original account holder had a Roth IRA, you can inherit a Roth inherited IRA. The main advantage of inheriting a Roth IRA is that qualified distributions, including earnings, are tax-free. However, there are still rules and requirements to follow.
Key rules of inherited IRAs
1. Take required minimum distributions.
One of the most crucial rules for beneficiaries of inherited IRAs is to understand and adhere to the required minimum distribution (RMD) rules. RMDs are the minimum amount that must be withdrawn from an inherited traditional or Roth IRA each year. The specific rules for RMDs depend on several factors, including the beneficiary's relationship to the original account holder, the age of the original account holder at the time of death and whether the beneficiary chooses to stretch the IRA over their lifetime or take a lump-sum distribution.
Spouse as a beneficiary: If a spouse inherits an IRA, they have the option to treat it as their own or roll it into their existing IRA. If they choose to treat it as their own, they will not be required to take RMDs until they reach age 72 or older based on the year they were born. (The Consolidated Appropriations Act of 2023 raised the age for required RMDs to 73 for those born from 1951 to 1959, and to 75 for those born in 1960 or after.) In addition, a spouse who inherits a Roth IRA and designates it as his/her own will not be required to take RMDs from the account.
Non-Spouse Beneficiary: Non-spouse beneficiaries typically have two options. They can choose to take RMDs over their own life expectancy (stretch option) or deplete the account within 10 years (10-year rule), depending on the circumstances. The stretch option can provide significant tax advantages by allowing the beneficiary to spread the tax liability over a more extended period. However, the stretch option is only available for “eligible designated beneficiaries” if the account holder died in 2020 or later. These would include a minor child, a disabled or chronically ill individual or an individual who is not more than 10 years younger than the IRA owner.
2. Be aware of the 10-year rule
The 10-year rule is a significant change that came into effect with the passage of the Setting Every Community Up for Retirement Enhancement Act in 2019. This rule applies to most non-spouse beneficiaries of inherited IRAs, and it requires them to withdraw all funds from the account within 10 years of the original account holder's death. There are no annual RMDs under this rule, but beneficiaries must ensure they comply with the 10-year deadline.
However, there are exceptions to the 10-year rule for certain eligible designated beneficiaries, including surviving spouses, minor children, disabled individuals and individuals not more than 10 years younger than the original account holder. These eligible beneficiaries may still use the stretch option and take RMDs over their life expectancy.
3. Understand tax implications
Taxes are a critical consideration when inheriting an IRA. Inherited traditional IRAs are subject to ordinary income tax on withdrawals, while inherited Roth IRAs generally offer tax-free distributions of both contributions and earnings. However, if a Roth IRA is inherited by a non-spouse beneficiary, RMDs may apply, but it is still tax-free.
Beneficiaries should be aware of the tax implications and plan their withdrawals accordingly. Consulting with a tax advisor can help optimize the tax strategy and minimize the tax burden.
4. Complete the beneficiary form and update it
It is essential for account holders to designate beneficiaries on their IRAs. Beneficiary designations take precedence over a will or other estate planning documents. If you are the beneficiary of an inherited IRA, ensure that the account holder had completed a beneficiary form, and that the information is up to date. Outdated or missing beneficiary designations can lead to complications and potentially unfavorable tax consequences.
5. Consider the implications of multiple beneficiaries
In some cases, an IRA may have multiple beneficiaries. When this happens, each beneficiary must determine his or her share of the inherited IRA assets and follow the relevant rules based on individual circumstances. This can get complex, especially if beneficiaries have different ages or tax situations. It is crucial to communicate and coordinate with co-beneficiaries to ensure compliance with IRS regulations.
Conclusion
Inheriting an IRA can provide financial security and opportunities for beneficiaries, but it also comes with a set of rules that must be followed to maximize the benefits and avoid penalties. Understanding the type of inherited IRA, the RMD rules, tax implications and beneficiary designations are key to navigating this complex financial landscape successfully.
Beneficiaries should take the time to educate themselves on the specific rules that apply to their situation and seek professional advice when necessary. Properly managing an inherited IRA can help secure a comfortable retirement for the beneficiary and ensure the original account holder’s legacy is preserved for future generations.
References:
Smith TJ. The greatest wealth transfer in history is here, with familiar (rich) winners. https://www.nytimes.com/2023/05/14/business/economy/wealth-generations.html. Published May 14, 2023. Accessed Nov. 8, 2023.
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
For more information:
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho. David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. He can be reached at 877-656-4362 or mandell@ojmgroup.com.
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