People commonly call IRAs they inherit an “inherited IRA.” However, an inherited IRA is an account most beneficiaries open to move funds into from an IRA or 401(k) left to them by a loved one or a friend.
In times past, legacy planning included saving ample funds in retirement accounts to leave your loved ones when you were gone. Beneficiaries who inherited these accounts could stretch annual inherited account distributions across their own life spans. But the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in 2019, eliminated the lifetime stretch benefit for IRAs and imposed a 10-year timeframe for most beneficiaries to deplete inherited accounts.
If you inherited an IRA in 2019 and prior years: All beneficiaries of inherited IRA funds are grandfathered into the old laws that you are already following. You can continue enjoying lifetime stretch benefits from your inherited IRA with no changes.
If you inherited an IRA in 2020 and afterwards: Unless you are a spouse or a specifically defined eligible beneficiary, you must follow a new 10-year rule to distribute the funds from and close the inherited IRA by the end of the 10th year after the death of your benefactor.
Non-spouse eligible beneficiaries are:
- Persons who are chronically ill or disabled at the time they inherit
- Individuals no less than 10 years younger than their benefactor
- Minor children (Note: Minors who inherit IRAs in 2020 and later must follow new rules as specified below.)
The new rules can feel somewhat daunting if you are not familiar with inherited IRAs to begin with. So, below we have compiled the basic rules under the SECURE Act for individuals who inherit IRAs. This information should help you understand IRS rules for beneficiaries who inherit IRAs.
For IRAs Inherited in 2020 and Beyond
Spouses have the following options:
(Remember, rules for spouses who inherit IRAs in 2020 and beyond are the same as they are for accounts inherited in 2019 and earlier.)
Traditional, SEP, and SIMPLE IRAs
- Take annual distributions from the inherited IRA over the course of your lifetime. You are unable to make contributions to this account, but you can still manage the assets and enjoy tax-sheltered income growth in the account.
- Retitle the inherited account in your name, which allows you to treat it as your own, to make contributions and begin distributions when you retire.
- Move funds into an existing IRA or qualified workplace plan and the funds can be treated as your own.
- Take a lump sum cash-out (taxes apply, but there is no penalty).
Roth IRAs:
- Take a lump-sum distribution and close the account. This withdrawal is tax free and penalty free only if the account is 5 or more years old.
- Open a Roth IRA in your name and deplete funds in the account within 5 years of the original account holder’s death.
- Leave the funds in the inherited account or transfer the funds to an existing or new Roth account. Both options allow you to treat the inherited funds as if they are your own.
Eligible beneficiaries (other than minor children) can:
- Open an inherited IRA and distribute funds annually over the course of your lifetime.
- Take a lump sum cash-out.
Eligible beneficiaries (other than minor children) as defined by the IRS:
- Individuals who are chronically ill or disabled
- Individuals no less than 10 years younger than their benefactor
Minor children:
Even though minor children are classified as eligible beneficiaries, their rules are a bit different.
- Minor children must take annual distributions from inherited funds until they reach the majority age of 18 or 21 (per state majority age requirement; in California the age of majority is reached at 18 years old).
- When a minor child reaches majority age, the 10-year rule starts, and the account must be emptied and closed within 10 years of the death of the original account holder.
All other non-spouse beneficiaries can:
- Open an inherited IRA and comply with the 10-year rule to deplete and close the account.
- Take a lump sum cash-out of all inherited funds.
Roth IRA rules for non-spouse beneficiaries:
- You can transfer funds into an inherited account, empty and close the account following the 10-year rule. If the original account had not been opened for 5 or more years before the original account holder’s death, taxes and penalties apply to all distributions. You may want to wait to take distributions when that 5-year timeframe arrives.
- You can take a lump sum cash-out of funds. Taxes and penalties apply if the account is less than 5 years old.
Additional Rules for Inherited IRAs:
- The 10-year rule for account distributions is flexible. You are not required to take distributions every year. In fact, you can take distributions whenever you want to and in any increment you desire. But you must make sure to distribute all funds before the 10-year deadline.
- If the original account holder was taking required minimum distributions (RMDs) but hadn’t taken one in the year of their death, you must take that distribution for that year. This distribution will not incur an early-withdrawal penalty for you.
- When a spouse opts to treat inherited funds as their own, they can make contributions to the account, take distributions within IRS guidelines, and manage/oversee investment funds within the account.
- If any beneficiary, including a spouse, opens an inherited IRA for funds you inherit, whether you opt to stretch the distributions over your lifetime or within the 10-year rule, you are unable to make contributions to the inherited account. However, you can still oversee the investments for the account for as long as it’s open.
Final Words from Pantheon Wealth Planning
It is important you understand the basics of the new rules for inherited IRAs under the SECURE Act. We strongly suggest you consult with your CPA or financial planner if you inherit an account. Depending on the type of account you inherit, distributions may be taxed as ordinary income. As this can create quite an unexpected tax liability for you, it will help to have a plan in place so that you are not surprised and are prepared to make the most of your inherited funds.