Note: This is an updated version of this blog: 10 Things to Consider if You Have Inherited an IRA. Some additional information is also provided including a discussion related to the potential impact of proposed regulations the IRS issued in February.
The COVID-19 pandemic has forced many families to unexpectedly settle an estate after the untimely death of a loved one. If you have recently inherited an individual retirement account (IRA), you may not know what rules apply. You’re not alone either. The IRS issued Proposed Regulations this past February. These rules included some unexpected twists and turns. These rules have created considerable confusion. We can’t be certain what the final rules will be. Hopefully, the IRS will provide additional clarification sometime soon.
The rules for inherited IRAs are different than those that apply to other IRA accounts as well. Inheriting an IRA can leave you trying to navigate the rules of estate planning, financial planning, and tax planning simultaneously. Making a wrong decision can cause expensive consequences. If you make a mistake, you may struggle to get the IRS to give you a do-over.
Here are 11 things you need to know if you inherit an IRA from someone other than your spouse. (Please note that this blog does not address what happens if someone under the age of 21 receives an inherited IRA.)
Consider all your options before doing anything with your inherited IRA.
You have time to make decisions. You do not need to rush. First, you want to make sure the original IRA custodian (often a brokerage firm) has been notified of the IRA owner’s death. You want to make sure the beneficiary account is set up properly as well. The account title should read: “[Owner’s name], deceased [date of death], IRA FBO [your name], Beneficiary” (FBO means “for the benefit of”). If you put the account in your name, the full value of the account gets treated as a distribution. That’s not what you want. Why? It means the entire amount gets reported as income when you make that transfer. It’s very difficult to undo this error.
Find out if the decedent took any required distributions in the year they died.
Say your father died on January 15, leaving you his IRA. He probably did not take his required minimum distribution (RMD). As the beneficiary, you must take it if the original owner didn’t. If you don’t know about or forget this rule, you can pay a penalty of 50% of the amount that you failed to distribute. This can be harder to determine on a timely basis if someone dies late in the year. What if your father dies on December 15 and hasn’t taken his full distribution? You may not even find out that you inherited the account, or if you do, you may not know how much he has taken year-to-date. The last day of the calendar year is the deadline for taking that year’s RMD. (Note that if the deceased was not yet required to take distributions, then there is no year-of-death required distribution.) If more than one beneficiary shares the account, you can allocate any year-of-death distribution based on the collective wishes of the group. (If you learn you are subject to the 50% penalty described above, you can use the steps outlined here to try and get the penalty waived.)
You cannot make any contributions to your inherited IRA.
Special distribution rules apply to inherited IRAs. These rules mean you cannot make contributions to an inherited IRA. You also cannot commingle inherited IRAs. If you inherit IRAs from different owners, they cannot be combined into a single inherited IRA. If they are inherited from the same owner, you may be able to combine them.
You can move your inherited IRA.
If you don’t like the investment choices offered by the custodian where the account was held, you can move the account. If you prefer to hold the account at a different custodian/brokerage, you can transfer it to that preferred custodian. You can invest the account in any way allowed by the custodian that holds the account. If you decide to move the account, you must move it by direct transfer. The new account must also be an inherited IRA titled the same way as noted above. The rule allowing you to take a distribution and roll it over within 60 days (the 60-day rule) does not apply to inherited IRAs.
No Roth conversions.
Unfortunately, you cannot convert an inherited IRA into a Roth IRA.
You will have to take distributions within a prescribed period.
If you inherited the IRA before 2020, you must take annual RMDs. (Note: the CARES Act waived the RMDs in 2020.) These RMDs are based on your age at the time you inherit the IRA. The IRS provides tables to help you calculate the amount. If you inherit the funds in 2020 or later, you must distribute the funds in the inherited IRA within a 10-year payout period. At first, most believed that you did not have to take annual distributions from these inherited IRAs. The thought was you could potentially have the entire balance sit in the account and wait until year 10 to distribute the full balance. Or you could at least wait if you expected your income would fall into a lower tax bracket during the 10-year period. For example, Apprise has some clients with inherited IRAs who plan to retire before the 10-year period ends. It could make sense for such individuals to wait to take distributions until they stopped working as that would lower the associated tax cost.
You will most likely have to take annual RMDs from an inherited IRA you received in 2020 or later.
This is where the proposed regulations changed the equation. They say you must take RMDs from post-SECURE Act Inherited IRA. Unfortunately, the IRS hasn’t provided specific guidance yet. The belief is that you will have to calculate an annual RMD in years 1-9. In year 10, you must distribute the balance of the account. You could take more in any year or take less than 10 years to distribute the account balance. But the account balance should be zero after 10 years have passed. When deciding how much to distribute each year relative to the RMD, you should take your financial plan and tax situation into account.
You can make a qualified charitable distribution (QCD) from an inherited IRA.
If you are charitably inclined and are age 70 ½ or older, you may be able to use QCDs to lower your tax bill. QCDs require you to move your funds directly to the charity of your choice in a tax-free transfer. QCDs represent a more tax-efficient way to make charitable contributions.
Don’t worry about age-related penalties.
For regular IRAs, you generally must pay a 10% penalty if you take distributions before age 59 ½. This early distribution penalty does not apply to inherited IRAs. If you inherit a traditional IRA or 401k, the distributions are subject to regular tax only.
What if you inherit a Roth IRA?
You still must withdraw the funds over the prescribed period. (10 years if you inherit the account in 2020 or later.) Distributions will most likely be tax-free. But you don’t have to take RMDs. You can let the account sit for 10 years and then distribute the entire balance.
Don’t forget to name a successor beneficiary.
When you inherit an IRA, you should name a beneficiary. If you don’t, the default provisions in the IRA document are likely to apply. As with most financial accounts, designating a beneficiary can keep the assets out of probate. This can save both time and money.
What should an inherited IRA beneficiary do now?
The changes to inherited IRAs discussed above seem likely to pass. But until that happens, it could make sense to consider a wait-and-see approach. If the inherited RMD distribution rules do change, make sure to consult your financial and tax professional to assess the implications and evaluate any potential tax planning opportunities. The tax impact may be significant, especially for beneficiaries who inherit a large retirement account in their prime earning years.
Knowing what to do when you inherit an IRA can be complicated. You must consider your current financial and tax situations. Estate planning considerations can apply as well. If you have inherited an IRA and have some questions, please schedule a free call.
I’ll be back next week with “Apprise’s Five Favorite Reads of the Week.”
Our practice continues to benefit from referrals from our clients and friends. Thank you for your trust and confidence.
We hope you find the above post valuable. If you would like to talk to us about financial topics including your investments, creating a financial plan, saving for college, or saving for retirement, please complete our contact form. We will be in touch. You can also schedule a call or a virtual meeting via Zoom.
Follow us: Twitter Facebook LinkedIn
Please note. We post information about articles we think can help you make better money-related decisions on LinkedIn, Facebook, and Twitter.
Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
