Wrapping up the estate of a loved one can be tricky. As the beneficiary, you’ll inherit some property and assets, which can certainly boost your net worth. However, inheritances are often a double-edged sword and you’ll want to tread carefully. That’s because you are potentially exposed to various tax liabilities, based on the type of asset you inherited and what you decide to do with it. One such asset is the inherited IRA. The key to minimizing your tax liability is educating yourself about inherited IRA rules and what action steps would best serve you. This guide will explain what an inherited IRA is, how it works, and several things you should be aware of, such as beneficiary IRA distribution rules. That way, if you’re someone who inherited an IRA, you’ll know exactly what to do next.
What is an Inherited IRA?
An Inherited IRA is an individual retirement account that you open after inheriting a tax-advantaged retirement account. A loved one in your life would have opened and contributed to an IRA, such as a private IRA or employer-sponsored retirement plan such as a 401(k), and named you as their designated beneficiary. (Learn more about financial beneficiary designations and how they intersect with estate planning here.)
After they pass away, their IRA account becomes rightful yours. Next, we’ll explain how this works and special tax considerations you should watch out for before taking any action.
How Does an Inherited IRA Work?
When you inherit a retirement account, you’re required to open a new IRA in your own name. Then, you would move the funds out of the deceased’s account into your account.
An inherited IRA could have originated as any type of IRA, such as a Roth, SEP, or SIMPLE IRA. If you find out that you inherited an IRA account from a loved one, find out what type of account they had. This is important to know because you’ll be receiving the same tax treatment when you open up your inherited IRA. If your loved one had a pre-tax IRA, then your inherited IRA will be treated as pre-tax. Conversely, if they had an after-tax IRA, then yours will be treated as such.
However, that’s just about the only straightforward thing about inherited IRA rules. The internal revenue services (IRS) imposes different sets of rules based on your relationship to the original account owner. Keep reading to find out what you need to know about inheriting an IRA and what choices you need to make.
What Should I Do If I Inherit an IRA?
Anyone can inherit an IRA, but the IRS assesses different tax treatments based on everyone’s unique circumstances. Before you do anything, you should educate yourself on what options you have, what your tax liabilities are, and what possible ramifications you may face based on which option you choose. Find out more about what you should do if you inherit an IRA here. Working with a financial advisor is also a great idea.
What Beneficiaries Need to Know About Inheriting an IRA
Now that you have an understanding of what an inherited IRA is, here are some best practices and helpful information that can help you through your decision-making process. The very first task at hand is deciding when you should take the money from the IRA you just inherited.
1. You need to choose when to take the money
Your options relating to when and how to take your IRA money largely depends on your relationship to the original IRA owner. If you are the spouse, then you have the most flexibility. For instance, you have the option of rolling over the IRA funds directly into your own account. Others do not have this option.
If you’re the spouse, chronically ill, disabled, a minor child, and are at least 10 years younger than the owner, you have two options:
The stretch option: take distributions throughout your life expectancy and leave the funds in the IRA as long as possible. This option provides the most shelter from taxes and allows the funds to grow over time.
The liquidation option: liquidate the IRA account within 5 years of the owner’s passing. This can lead to a hefty income tax bill, unless the account in question was a Roth IRA (taxes were already paid before money hit the account.)
Due to the 2019 SECURE Act, anyone who doesn’t belong to this first category is forced to liquidate the IRA in entirety within 10 years. This means that you’ll face an income tax and don’t have the stretch option at your disposal. However, you still can take minimum required withdrawals every year until you hit the 10 year period to manage your tax liabilities as much as possible.
2. Consider year-of-death required distributions
Next, find out whether or not the original IRA owner took their required minimum distributions in the year that they passed away. If they didn’t, this means that the responsibility is passed on to you. As the beneficiary, you have to make sure this minimum is met. The deadline is the last day of the calendar year in which the account owner passed away. This can create problems if your loved one passes away closer to the end of the year. You would have less time to figure out there is a problem and you would risk not meeting the deadline.
If your loved one wasn’t required to take distributions yet, then lucky you. There are no concerns or consequences related to this requirement.
3. Spouses receive greater benefits from inheriting an IRA
Were you married to the original IRA owner? You’ll be happy to find out that you receive the most leeway and benefits. As the surviving spouse, you have several options to choose from:
Assume the IRA as your own and simply change the name on the account
Roll the funds into any account of your own
Treat yourself as the beneficiary of the plan
The decision you make will likely be up to the various advantages and disadvantages of each choice.
4. Don’t disregard beneficiary forms or trust designations
Regardless of your relationship to the IRA owner or the decision you make with regards to what to do with the account, pay special attention to your beneficiary form or Trust designation. A missing or incomplete form can sink an estate plan, so you’ll want to stay on top of this. A missing beneficiary means that the IRA account gets included as a part of the deceased’s estate. Then it will be subject to the five-year rule for distributions. Talk about a road block!
Be sure to take a look at the IRA’s beneficiary designation and make sure that it is correct, up-to-date and intact. The account can be designated to a person or a Trust account.
Update Your Estate Plan Today
When it comes to estate planning, IRA accounts are often overlooked. This is because when an account owner sets up a beneficiary designation for the account, they feel assured that the assets won’t be included as a part of their estate. While this is technically correct, IRA accounts without a doubt should always be considered in your overall estate planning strategy.
When a beneficiary designation is in place, the asset passes directly to the heir. The account is not included as a part of the estate and does not go through the probate process. However, things take a turn for the worse when the beneficiary designation is outdated, incorrect, or missing. All of a sudden, the account is included in the estate, passes through probate, and won’t reach the hands of the heir for five years. This is why the “set it and forget it” strategy is a grave mistake.
Instead, it’s wise to always consider every asset under your name as a part of your Estate Plan, even if it is not necessarily included in your final estate. Keep a running, updated list of all assets that have beneficiary designations and set a reminder to review and update your documents at the same time that you review and update your Estate Plan. That way, you can have better peace of mind knowing that your IRA account will pass directly to your loved one so that they can obtain their inherited IRA without delay. Knowing your inherited IRA rules will also make the planning process that much easier.
Here, we have great news! Trust & Will’s user-friendly platform makes it easy for anyone to plan their estate, including the management of their retirement accounts and beneficiary designations. Whether you want to set up a Will or a Trust, we have options to suit your unique needs. The first step is finding out what kind of plan you should have, and we can help by matching you with the right one. Take our quiz to get started today.
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