Inheriting an IRA? Understand Your Choices

Managing your own retirement accounts can be confusing, but an inherited retirement account can be even more complex—especially with the IRA rules introduced by the two SECURE Acts. The new rules only impact individuals who inherit a retirement account from someone who passed away in 2020 or later. Generally, individuals who inherited retirement accounts in 2019 or before will fall under the old rules—however, any successor beneficiary who inherits a retirement account in 2020 or after will also be covered by the new rules.

The rules for an inherited account are based primarily on the type of beneficiary you are and your relationship to the original account owner. There are three main types of beneficiaries for a retirement account:

• Designated beneficiary: The individual listed on the retirement account who will receive it upon the owner's death.
• Eligible designated beneficiary: A special type of designated beneficiary who is "eligible" for special treatment under the SECURE Act 1.0 rules. Five types of individuals fall into this category:
  • Spouse of the account owner
  • Minor child of the account owner (applies only to the direct descendant, not a grandchild, under age 21)
  • Anyone who is less than 10 years younger than the account owner (for instance, a sibling)
  • Chronically ill individual, as defined by IRC 7702B(c)(2), at the date of the account owner's death
  • Disabled individual, as defined by IRC 72(m)(7), at the date of the account owner's death
• Beneficiary via a will or estate: The individual determined by the will or estate to receive the retirement account when no designated beneficiary is named.

The type of beneficiary you are and the age of the original account owner will typically determine the actions you can take when you inherit a retirement account. However, if the original account owner was of required minimum distribution (RMD) age but hadn't taken all their RMDs before death, you must withdraw their remaining RMD by the end of the current year—or risk paying up to a 25% penalty on the RMD that was not taken out.

That said, let's look at your options, including distribution requirements and any tax consequences.

Available to all beneficiaries

Regardless of your relationship with the account holder, you can opt to disclaim, or not accept, the inheritance. The assets would then pass on to an alternate beneficiary, such as another family member, or to the estate if no other beneficiaries are named. Disclaiming the IRA can be a smart option if you're financially secure and want to avoid potential tax consequences of the additional income. Be aware that you'll need to disclaim the account within nine months of the original owner's death and before taking possession of any assets.

Available to all beneficiaries

As the beneficiary, you may distribute the account assets in a lump sum without facing a 10% early withdrawal penalty. (If you inherit a Roth IRA, the account must have been open for at least five years to avoid paying a penalty.) There are a couple of downsides to distributing all the assets however.

First, if it's a tax-deferred account (like a traditional IRA), the IRS will tax the funds as ordinary income, which could move you into a higher tax bracket. Also consider that by not keeping those assets in a tax-advantaged account, you could lose out on the potential growth of any additional tax-deferred appreciation.

Available only to the surviving spouse

If your spouse lists you as beneficiary, you have the option to roll over the funds to your own IRA where the money can potentially continue to grow tax-free. That said, if your spouse was subject to RMDs and hadn't yet taken the whole amount, you must remove the undistributed amount for that year at the time of transfer.

Once the funds are in your account, subsequent withdrawals follow the rules of your IRA, not the inherited account. For example, if you want to withdraw funds but are not 59½, you may have to pay a 10% early withdrawal penalty. Assuming the money was tax-deferred, you'll also owe taxes on the distribution—the same as with any traditional IRA.

Available only to eligible designated beneficiaries (Note: There is a limit to this rule for a minor child.)

Assuming you don't need all the money at once, you could transfer the funds into an inherited IRA held in your name, sometimes referred to as a "stretch" IRA. This option enables you to take annual RMDs over many years, allowing the bulk of the money more time to potentially grow tax-deferred.

Typically, you must begin taking RMDs no later than December 31 of the year following the original account holder's death. If the original account owner was under the RMD age, your life expectancy will be used to determine the distribution amount. If the original account owner had reached their RMD age, then RMDs from the account can be spread out over your life expectancy or the remaining life expectancy of the original account holder, whichever is longer.

There are two exceptions to this general rule:

• A spouse will be able to wait to take RMDs until December 31 of the year in which the decedent would have had to take those RMDs.
• A minor child is only allowed to stretch out distributions until they reach 21, the age of majority. Once they turn 21, they must follow the 10-year rule (see "Distribute the assets within 10 years").

Available to all designated beneficiaries and a minor child who has reached the age of majority

Under the 10-year rule, all assets in the inherited retirement account must be withdrawn before the end of the 10th year to avoid penalties on the undistributed amount. For a minor child, the 10-year rule kicks in once they reach age 21.

Based on final regulations from the IRS, some beneficiaries will also have to take annual RMDs depending on the age of the original account owner:

• If the original account owner was under the RMD age at the date of death, you will not need to take annual RMDs.
• If the original account owner was of RMD age at the date of death, you must start taking annual RMDs based on your life expectancy. If you're a designated beneficiary, you must start taking RMDs beginning December 31 of the year following the original account holder's death. If you inherited the account as a minor child, your first RMD must be taken by December 31 of the year of your 21st birthday.

Generally required by those who are not designated beneficiaries

If you're not listed as a designated beneficiary on the retirement account, you likely inherited the account via a will or the estate. In this situation, the age of the original account owner will determine how you must distribute the assets:

• If the original owner was under the RMD age at the date of death, the 5-year rule applies. Under this rule, you won't have an annual RMD, but you must withdraw all assets within five years of the owner's death or else pay a penalty on any remaining amount.
• If the original owner was of RMD age at the date of death, you generally must take RMDs over the remaining life expectancy of the original account owner.

Given the complexity of these new rules, a tax, estate, or financial advisor can provide guidance on your options, explain requirements, and help you implement a tax-efficient withdrawal strategy if you inherit a retirement account. If you need to name a beneficiary to your own retirement accounts, it's a good idea to meet with a tax, estate, or financial planning professional to make sure your accounts are set up to carry out your wishes.