Inherited IRAs are subject to comprehensive federal rules.
An important part of retirement planning is saving money in a traditional IRA or 401(k).
These tools provide an opportunity to save for retirement while deferring taxes on the contributions.
Through investment, these accounts can grow to provide a sizable income for you in retirement.
According to a recent CNBC article titled “Here’s how to handle the complicated rules for an inherited 401(k) or IRA,” the federal government eventually wants to tax these savings and their growth.
One way the government accomplishes this is through Required Minimum Distributions, also known as RMDs.
When retirees reach a certain age (now age 72), they must withdraw a certain amount of money from these accounts each year.
These withdraws are then taxed as ordinary income.
Another way the government has ensured taxes will be paid on these fund is through legislation like the 2019 Secure Act.
What did this Act accomplish?
It changed the rules governing the treatment of inherited IRAs after the death of the original owner.
After January 1, 2020, most heirs are no longer able to “stretch” distributions from these account over their own lifetimes.
Inherited IRAs must now be depleted within 10 years, with very limited exceptions.
For example, minor children find some grace here.
This “grace period” ends, however, when the child turns 18 in most states.
At this time, the child must draw down the account within ten years and take annual required minimum distributions calculated from his or her own life expectancy.
Disabled beneficiaries or who are “chronically ill” (as defined by the tax code), may also find an exception to the ten-year rule.
In addition, heirs not more than 10 years younger than the original IRA owner.
What should heirs do if subject to the ten-year rule?
They should create an inherited IRA and transfer the funds to it.
Other steps will depend on the type of account inherited, the method of inheritance, and whether the original IRA owner had begun taking RMDs.
With a traditional IRA, distributions are taxed when the withdraws are made.
With a Roth IRA, withdrawals are usually tax-free unless the Roth is fewer than five years old.
If this is the case, earnings are subject to taxes but the amount contributed after taxes remains tax-free.
If inherited IRAs pass through an estate rather than beneficiary designations, the accounts must be emptied within five years if the original owner had not started taking RMDs.
If the decedent had already begun taking the RMDs, the heir would need to continue taking the distributions as if the original owner were still alive (the so-called “ghost” rule).
Rules for inherited IRAs are different for spouses.
The spouse can roll the money into his or her own IRA and follow the standard rules for Required Minimum Distributions.
Withdrawals are made starting at age 72 based on the life expectancy of the surviving spouse.
Money can be left in the account until this time and continue to grow untouched.
If you are a surviving spouse and not yet age 59 ½ and need the income, you can make withdraws but these will be subject to a 10 percent penalty for taking premature withdraws.
Alternatively, if you are the surviving spouse and need the money now, it may be better to place the money into an “inherited IRA” account and make yourself the beneficiary.
Because the rules governing inherited IRAs can be complicated, work with an experienced estate planning attorney to create a plan for distributing your retirement funds to heirs.
Reference: CNBC (April 11, 2021) “Here’s how to handle the complicated rules for an inherited 401(k) or IRA”