Inheriting money is generally not a taxable event to the beneficiary. The federal estate tax may apply to the deceased's estate, but the beneficiary is not taxed on the decedent’s assets. However, if the decedent owned an individual retirement account passed to heirs, the heirs would normally pay tax on withdrawals they eventually make from these investments.
The beneficiary does not pay tax on the title change from the deceased’s IRA to the beneficiary! The beneficiary will owe tax when eventual distributions from the IRA are made. Beneficiaries of retirement plans and IRA accounts after the account owner's death are subject to required minimum distribution (RMD) rules. Not all distributions from beneficiary IRAs will be taxable, including non-deductible contributions the deceased account owner made to an employer plan (eventually rollover to IRA) or personal IRA. In addition, the distributions from an inherited Roth IRA will receive the same tax treatment as the deceased’s Roth IRA – tax-free¹. See below for more on Roth.
¹Provided the account is at least five years old, and the recipient is at least fifty-nine and a half.
Once the inherited IRA is set up, the beneficiary can immediately choose to liquidate the account and receive a lump sum payment. However, the amount withdrawn could trigger higher tax brackets resulting in higher taxes. Spreading out distributions over time typically results in lower taxable income each. Before 2020, it was possible to “stretch” the distributions of an inherited IRA over the beneficiary's expected lifetime. Children or grandchildren designated as beneficiaries could mean decades of tax-deferred growth on the original contributions of the deceased account owner. The Secure Act of 2020 changed the rules for beneficiaries of IRAs. The ability to stretch IRA distributions has been curtailed by limiting the time a non-spouse can defer the tax liability of the transferred IRA value to a maximum of ten years.
How beneficiary RMDs are determined.
Factors that affect the distribution requirements for inherited retirement plan accounts and IRAs include:
- Whether the account owner died after 2019 (the SECURE Act changed the RMDs for beneficiaries if the account holder's death occurred after 2019).
- The relationship of the beneficiary to the account owner and specific characteristics (spouse, minor child, disabled or chronically ill individual, entity other than an individual)
- Whether the original account owner died before or after their required beginning date (the first date the original account owner was required to begin taking RMDs).
The account owner's spouse has more options than non-spouse beneficiaries if they're the sole beneficiary. Determination of whether the spouse is the sole beneficiary is made by September 30 of the year following the year of the account holder's death. For the year of the account owner's death, the RMD due is the amount the account owner was required to withdraw and did not withdraw before death.
Death of the account holder occurred in 2020 or later
Spousal beneficiary options
If the account holder's death occurred before the required beginning date, the spouse beneficiary may:
- Keep it as an inherited account.
- Delay beginning distributions until the account owner reaches their Required Beginning Date (see definitions below).
- Take distributions based on surviving spouse's life expectancy, or
i) Follow the 10-year rule.
- Roll over the account into their own IRA.
If the account holder's death occurred after the required beginning date, the spouse beneficiary may:
- Keep it as an inherited account.
i) Take distributions based on surviving spouse's life expectancy, or - Rollover the account into their own IRA
Non-spouse beneficiary options
In 2020 and later, options for a beneficiary who is not the spouse of the deceased account owner depend on whether they are an "eligible designated beneficiary." An eligible designated beneficiary is
- Spouse or minor child of the deceased account holder
- Disabled or chronically ill individual.
- An individual who is not more than ten years younger than the IRA owner or plan participant
An eligible designated beneficiary may
- Take distributions over the longer of their life expectancy and the employee's remaining life expectancy or
- Follow the 10-year rule (if the account owner died before that owner's required beginning date)
Designated beneficiary (not an eligible designated beneficiary)
- Follow the 10-year rule
A beneficiary that is not an individual (estates, trusts, business)
- Follow the rules described above as if the account owner died before 2020 (because the SECURE Act changes only apply to beneficiaries who are individuals)
To View RMD rules before 2020, please see Publication 590B: Distributions from Individual Retirement Accounts
Planning Points:
Surviving Spouse
The surviving spouse has the most flexibility regarding how the inherited IRA is treated. One of the options is to have their spouse’s IRA roll over into their IRA, thereby converting the Beneficiary IRA status into the surviving spouse's traditional IRA. The benefits of the surviving spouse converting the IRA into their own are:
- They can continue contributing to an IRA if they qualify (they need income to qualify).
- They can convert the IRA into a Roth IRA. They would need to pay taxes on converted amounts.
- They can roll over their IRA to qualified employer plans or have employer plans or other IRAs rolled into their new IRA.
None of the actions above are permitted with a Beneficiary IRA. However, beneficiary IRAs can be consolidated if the IRAs are from the same decedent.
Non-Spouse Beneficiaries
- Passing IRAs to a child or grandchild may still result in lower taxes since the child will likely have a lower tax rate than older beneficiaries. However, once the child turns 21, the 10-year rule will kick in (see example below).
- The beneficiary can invest the after-tax funds into another tax-saving vehicle, such as a Roth IRA. The beneficiary would need earned income and qualify for contributions.
- Non-spouse beneficiaries can take the funds in year one, year ten, or anywhere in between. The funds withdrawn are fully taxable at ordinary income tax rates.
Examples
Passing an IRA from one spouse to another.
Gerald, age 70, passed away in 2021. His wife, Carolyn, is 65 years old. Gerald had an IRA, which lists Carolyn as the sole beneficiary. Gerald had not begun receiving RMDs from his IRA yet. Carolyn can roll over the IRA into her name, allowing her to wait until age 73 to start her RMDs. Even if Gerald had begun his RMD payments at his death, Carolyn would still have the option of treating the IRA as her own.
If a non-spouse beneficiary (natural person) is more than ten years older than the deceased account owner, the 10-year rule will apply. Otherwise, the beneficiary’s life expectancy can be used.
In 2022, Wendy passed away at age 80. She had an Individual IRA. She is widowed, has no children, and left her IRA to her two sisters, Jane and Julie, who are 72 and 68, respectively.
Since Jane is only eight years younger than Wendy, she qualifies as an eligible designated beneficiary. She can use her life expectancy or follow the 10-year rule for the RMDs. Julie is twelve years younger and fails to meet the eligible designated beneficiary requirements and, therefore, must follow the 10-year rule.
Passing an IRA to a minor child can be based on the child’s life expectancy until the child reaches age 21.
Kenneth is the beneficiary of his Grandma’s Traditional IRA. Ken’s grandma passed away in 2022, and Kenneth, age 16, qualifies as a minor child under 21, which allows the RMDs to be based on Kenneth’s life expectancy. But once Kenneth reaches 21, he is no longer considered a minor child and does not qualify as an eligible designated beneficiary. Kenneth must comply with the non-spouse beneficiary rules and withdraw the entire amount within ten years of the account owner’s (Grandma) death. Therefore, the entire amount of the IRA must be withdrawn by the end of 2032 (ten years following death).
Inherited Roth IRAs
Generally, the distributions from an inherited Roth IRA will be treated similarly to distributions from a traditional Roth IRA - tax-free. Although future withdrawals from the Roth IRA are tax-free, the 10-year rule will apply, and the account must be “cleaned out” before the end of the 10th year following the year of death of the deceased account owner. However, withdrawals of earnings may be subject to income tax if the Roth account is less than five years old at the time of the withdrawal.
Distributions from another Roth IRA cannot be substituted for these distributions unless the other Roth IRA was inherited from the same decedent.
Distributions to beneficiaries from qualified retirement plans
If the distribution is from a qualified retirement plan, such as a 401(k) or profit-sharing plan, the plan document establishes the distribution options available to satisfy the RMD rules. The plan administrator should provide the beneficiaries with their distribution options. If the beneficiary is the account owner's spouse, they may have more distribution options in the plan than a non-spouse beneficiary. Beneficiaries should contact the plan administrator for distributions from a qualified plan.
Additional Resources:
Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs)
Publication 554, Tax Guide for Seniors
Publication 559, Survivors, Executors, and Administrators
Publication 575, Pension and Annuity Income
Definitions
The 5-year rule: If a beneficiary is subject to the 5-year rule,
- They must empty the account by the end of the 5th year following the year of the account holder's death.
- 2020 does not count when determining the five years.
- No withdrawals are required before the end of that 5th year.
10-year rule: If a beneficiary is subject to the 10-year rule,
- Empty the entire account by the end of the 10th year following the year of the account owner's (or eligible designated beneficiary's) death.
- Relief under Notice 2022-53 for beneficiaries subject to the 10-year rule
- The IRS will not treat a beneficiary of an inherited account in a plan or IRA subject to the 10-year rule and who failed to take an RMD for 2021 and 2022 as having failed to take the correct RMD.
Eligible designated beneficiary
- Spouse or minor child of the deceased account holder
- Disabled or chronically ill individual.
- An individual who is not more than ten years younger than the IRA owner or plan participant
Designated beneficiary
- Any individual designated as the beneficiary of an IRA or retirement plan
Required beginning date
- The first date the original account owner was required to begin taking RMDs.
At Carr Wealth Management, LLC, our mission is to help guide our clients to accomplish their financial goals. We are an independent fiduciary and a Registered Investment Advisor. Anthony B. Carr, CPA, CFP®, has managed client investments for over 24 years. Please visit our website to view other blogs and more information on the planning and investment services we provide. Don't hesitate to contact us if you have questions or want to schedule a no-charge consultation. Thank you.