Beneficiary IRAs - What To Know
A Beneficiary IRA, also known as an Inherited IRA, is an Individual Retirement Account that is passed to a designated beneficiary after the original owner's death. The beneficiary can be a spouse, a child, another relative, or even an entity like a trust or charity.
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) and time limit rules. Not all distributions from beneficiary IRAs will be taxable, including non-deductible contributions the deceased account owner made to an employer plan (eventually rolled over to an IRA) or a 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the inherited IRA is set up, the beneficiary can immediately choose to liquidate it and receive cash, but the amount withdrawn could trigger higher tax brackets, resulting in higher taxes. Spreading out payments over time will result in lower taxable income each year instead of a lump sum payment.
Before 2020, it was possible to “stretch” the distributions of an inherited IRA over the beneficiary's expected lifetime. Designating children or grandchildren 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.
The next factor in determining the applicable rule is whether the beneficiary is eligible to lengthen the deferral period past 10 years (see “eligible designated beneficiaries below). Another factor is whether or not the deceased account owner had begun taking their RMDs at the time of their death (reached their required beginning date). And finally, the rules are different for a surviving spouse and a non-spouse beneficiary.
Options for Surviving Spouse
If the spouse is the sole beneficiary, things are not so complicated - they may roll the deceased spouse’s IRA into the surviving spouse's name and treat it just as they would if the IRA were their own. Whether the decedent died before or after 2020, or whether they were receiving payments at the time of their death, will not affect the ability of the surviving spouse to roll it over to their own IRA.
The benefits of converting to a personal IRA are:
o They can continue contributing to an IRA if they qualify (i.e., they need to have earned income).
o They can convert the IRA into a Roth IRA. They would need to pay taxes on converted amounts.
o They can roll over their IRA to a qualified employer plan, or have an employer plan or other IRAs rolled into their new IRA.
The surviving spouse has the following options in addition to treating the IRA as their own:
o Create a Beneficiary IRA. The RMDs can be based on when the decedent spouse would have been required to begin his or her RMDs, or when the surviving spouse reaches their required beginning date, or
o Follow the Ten-Year Rule (see below).
Options For Non-Spouse Beneficiary
A non-spouse beneficiary must first identify whether they are considered an “eligible designated beneficiary.” An eligible designated beneficiary is:
o Spouse or minor child of the deceased account holder
o Disabled or chronically ill individual.
o 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 decedent’s remaining life expectancy, or
Follow the 10-year rule
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).
Examples
You are passing an IRA from one spouse to another.
Gerald, age 70, passed away in 2021. His wife, Carolyn, is 65 years old. Gerald has 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 75 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's) death. Therefore, the whole amount of the IRA must be withdrawn by the end of 2032.
FAQs
Do I need to pay taxes on an inherited IRA?
If you take a lump sum from an inherited IRA, you'll owe taxes on the amount. However, if you choose to establish a Beneficiary IRA account for yourself, you may be able to defer taxes by spreading your distributions out over the ten-year maximum period.
Do spouses of the decedent use different rules?
Yes, spouses have different and more flexible rules for inherited IRAs compared to non-spousal beneficiaries, primarily because they can choose to treat the inherited IRA as their own. This allows them to roll it into their own IRA, benefiting from tax-deferred growth and delaying Required Minimum Distributions (RMDs) until age 73. Alternatively, spouses can keep it as a separate inherited IRA and take distributions over their own life expectancy.
How soon must I withdraw the funds from the IRA?
Inherited IRAs must generally be fully distributed within 10 years of the original owner's death, but this 10-year rule doesn't apply to certain "eligible designated beneficiaries” such as spouses, disabled individuals, or children under the age of majority.
Are contributions allowed for an inherited IRA?
No, you cannot make contributions to an inherited IRA
