Rules on Inherited IRAs and Other Post-Death IRA Issues
When you are the named beneficiary of an individual retirement account (IRA) and the owner of the IRA dies, you receive as an inheritance the amount in the IRA. Under current tax law, the inheritance passes to you tax-free, that is you do not pay taxes at the time the IRA ownership passes to you. But you are still required to take distributions from the account, which may be taxable. We will briefly explore the different type of IRA accounts and their taxability to the beneficiary of that account.
If you inherit a Traditional IRA, i.e. the amounts put into the IRA were deductible by the taxpayer on his or her tax return, the entire amount you withdraw from that IRA will be taxable to you.
If you inherit a non-deductible IRA, i.e. the taxpayer made non-deductible contributions to the IRA and the earnings in the IRA are tax deferred until withdrawn, only part of the distribution to you is taxable. The non-deductible portion of the original contribution to the IRA is not taxable while the earnings that were deferred are taxable upon withdrawal. In order to know what portion is taxable upon withdrawal, you will need to know the amount of non-deductible contributions made by the deceased. The ratio of non-deductible contributions over the total value of the IRA multiplied by the amount of the total distribution received will be the non-taxable portion to you.
If you inherit a Roth IRA, any distributions to you are likely tax free. The Roth IRA must have been held by the owner for at least five years , starting January 1 of the year in which the first Roth IRA contribution was made. If the Roth IRA had not been open for five years, the treatment is the same as non-deductible IRAs. The contribution portion of any distribution is not taxable and the earnings portion is taxable.
Required Minimum Distributions
The Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act) changed the rules for required minimum distributions from an inherited IRA for beneficiaries. The SECURE Act changed the age of required minimum distributions to 72 from 70 ½ for all taxpayers. In addition, the Act changed the time by which a beneficiary must withdraw all of the funds from the inherited IRA from the life expectancy of the beneficiary to no more than 10 years from the date of death of the IRA owner. Under the 10-year rule, the entire balance of the IRA must be distributed prior to the end of 10 years from the date of inheritance, regardless of the age of the beneficiary. Taxes are due (if applicable depending on the IRA type) with the withdrawals. There is no 10% penalty on the withdrawal since it is a statutory requirement to empty the account within 10 years.
Exceptions to 10 Year Rule
There are exceptions to the 10 year payout requirement for inherited IRAs. These exceptions generally apply to a surviving spouse, disabled or chronically ill persons, a minor child, or a person not more than 10 years younger than the IRA account owner.
If you are a surviving spouse and sole beneficiary of the deceased spouse’s IRA, you can elect to be treated as the owner of the IRA and not the beneficiary. By making this election, the required minimum distribution (RMD) amounts are determined using your age as if you were the owner of the account beginning with the year in which you make the election.
If you do not make this election, but remain as a beneficiary, special rules also apply to the surviving spouse. If the original owner had already started getting RMDs or had reached the required beginning date for RMDs at the time of death, the spouse can continue the distributions as were originally calculated based on the deceased owner’s life expectancy by remaining a beneficiary of the IRA. If the original owner had not begun taking RMDs, the surviving spouse may defer taking distributions until the date at which the spouse owner would have been required to take a RMD.
If the beneficiary is a minor child, RMDs are calculated using the child’s age until the child reaches the majority age in their state (typically 18 years of age). At that point, the ten-year payout rule goes into effect and the individual has 10 years to empty the account.
If the beneficiary is disabled or chronically ill, the annual RMD is calculated based on the life expectancy of the beneficiary and there is no 10-year rule to be applied.
If the beneficiary is within 10 years of the age of the deceased, withdrawals from the RMD can be based on the life expectancy of the beneficiary with no applicable 10-year rule.
If you have inherited an IRA or if you would like to discuss further beneficiary tax implications of an IRA, contact Stanfield + O’Dell.