When someone inherits an individual retirement account (IRA) from a deceased person, they find themselves at the crossroads of making tax planning decisions where the wrong move can lead to expensive consequences. The options available to the beneficiary of the inherited IRA depends on the type of IRA is originally was and the individual’s relationship to the deceased owner. This blog article will explain the unique issues related to inherited IRAs that you should know about.
WAS THE INHERITED ACCOUNT A TRADITIONAL IRA OR ROTH IRA?
The treatment of your inherited IRA will depend if the account was made with pre-tax dollars (like a traditional IRA) or after-tax dollars (like a Roth IRA).
Traditional IRAs are created by 26 U.S.C. §408. Qualified contributions to traditional IRAs are tax-deductible. 26 U.S.C. §219(a). However, distributions from traditional IRAs are full taxable income. Distributions are taxed at ordinary tax rates. Accountholders of traditional IRAs must make required minimum distributions (RMDs) by April 1 following the year that they reach age 72 based on specific calculations. Account owners that fail to take RMDs when required are subject to the excess accumulation penalty which is 50% of the amount that the person should have taken as an RMD but did not.
Roth IRAs are created by 26 U.S.C. §408A and offer the opposite benefit. Although contributions are not tax-deductible, qualified distributions are tax-free. 26 U.S.C. §408A(c)(1); 26 U.S.C. §408A(d)(1). In addition, there are no RMD rules for Roth IRAs and the account owner is not required to make withdrawals at age 72 (although he or she may do so tax-free anytime after age 59 1/2). There are no RMDs because the IRS already collected taxes on the original contribution. In addition, Roth IRAs are subject to a 5-year rule that requires the account to be in existence for 5 years before any tax-free distributions can be made.
To ensure that both types of IRAs are used for retirement purposes and not as general tax-advantaged savings vehicles, Congress made certain withdrawals from both types of accounts subject to a 10% early withdrawal penalty if taken before an accountholder reaches the age of 59 1/2. 26 U.S.C. §§ 72(t)(1)-(2). While some exceptions apply to the early withdrawal penalty, the 10% rule affects both traditional and Roth IRAs equally.
An inherited IRA retains the same character of the type of IRA it was in the hands of the accountholder, whether it was a traditional IRA or Roth IRA. If it is a Roth IRA, the distributions are not taxable to the beneficiary in the same way it is not taxable to the accountholder. If it was a traditional IRA, income taxes apply but would not be due until the year that the distributions are taken.
SPOUSES INHERITING AN IRA HAVE THE MOST OPTIONS AVAILABLE
If a spouse inherits a traditional IRA, then he or she has the following three options available:
- (1) Treat it as his or her own IRA by designating himself or herself as the account owner. This means that the spouse can continue to make contributions to the account as the original owner was permitted to under law, or make distributions with all the tax consequences that the original owner was subject to (based on the surviving spouse’s age). The 10% early withdrawal penalty before age 59 ½ on distributions still applies to spouses who are designated as the account owner.
- (2) Treat it as his or her own by rolling it over into a traditional IRA, or to the extent it is taxable, into a qualified employer plan, qualified employee annuity plan (section 403(a) plan), tax-sheltered annuity plan (section 403(b) plan), or deferred compensation plan of a state or local government (section 457(b) plan). If a surviving spouse receives a distribution from his or her deceased spouse’s IRA, it can be rolled over into an IRA of the surviving spouse no later than 60 days after the distribution (unless the distribution was required). 26 U.S.C. §408(d)(3). This can be done even if the surviving spouse is not the sole beneficiary of his or her deceased spouse’s IRA.
- (3) Treat himself or herself as the beneficiary of an inherited IRA rather than treating the IRA as his or her own. The beneficiary of an inherited IRA may never make contributions to the account. 26 U.S.C. §219(d)(4). In addition, distributions from an inherited IRA are subject to the SECURE Act of 2019 (discussed later), meaning that the spouse will have to make distributions over their own life expectancy or within a period of 10 years. Beneficiaries of inherited IRAs are not subject to the 10% early withdrawal penalty.
A spouse can also simply take a lump sum distribution from the deceased spouse’s traditional IRA, but will be responsible for all of the income taxes for that amount at ordinary tax rates in the year that the lump sum was received. This large influx of taxable income may push the taxpayer into a much higher tax bracket than what would have been realized if the distributions were taken over several years.
If a spouse inherits a Roth IRA, then he or she has two options available:
- (1) If the surviving spouse is the sole beneficiary of the account, then he or she can be designated as the new accountholder in a “spousal transfer” and, as a result, is not subject to RMDs during his or her lifetime and can withdraw the money anytime tax-free after age 59 1/2. The 5-year rule still applies to distributions for the spouse to be tax free as long as the account has been open 5 years or longer. Finally, the 10% early withdrawal penalty before age 59 ½ on distributions still applies to spouses who are designated as the owner.
- (2) If the surviving spouse is not the sole beneficiary (or chooses not to be the new accountholder), then he or she can roll over their portion of the Roth IRA into an inherited or beneficiary IRA account. However, RMDs at age 72 would apply in the case of an inherited Roth IRA. Further, distributions from an inherited IRA (even Roth IRAs) are subject to the SECURE Act of 2019 (discussed later), meaning that the spouse will have to make distributions over their own life expectancy or within a period of 10 years. In addition, the 5-year rule applies as the original account must have been opened at least 5 years. Beneficiaries of inherited IRAs are not subject to the 10% early withdrawal penalty.
A spouse can also take a lump sum distribution of a deceased spouse’s Roth IRA tax-free, provided that the original account was open for at least 5 years. However, since distributions from a Roth IRA are tax-free, a spouse taking a lump sum could be missing out on the opportunity for the funds to continue to be invested and generate even more tax-free money.
NON-SPOUSE BENEFICIARIES HAVE LESS OPTIONS FOR AN INHERITED IRA
If the inherited traditional IRA is from anyone other than a deceased spouse, the beneficiary cannot treat it as his or her own, cannot make any contributions, and cannot rollover any amounts in and out of the IRA. However, the beneficiary can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. Like the deceased owner, the beneficiary generally will not owe tax on the assets in the traditional IRA until he or she receives distributions from it.
If the inherited Roth IRA is from anyone other than a deceased spouse, the beneficiary must generally distribute the entire amount by the end of the fifth calendar year after the year of the owner’s death. Distributions from a Roth IRA remain tax-free in the hands of the beneficiary.
For any kind of inherited IRA, the 10% early withdrawal penalty does not apply.
NON-SPOUSE BENEFICIARIES MUST LIQUIDATE AN INHERITED IRA WITHIN 10 YEARS
The Setting Every Community Up for Retirement Enhancement Act (SECURE Act) of 2019 significantly changed the rules regarding distribution periods from both traditional IRAs and Roth IRAs. Before this law was passed, most non-designated beneficiaries were subject to a five-year period to liquidate accounts. Now, the SECURE Act creates a ten-year period to liquidate inherited IRAs for most designated beneficiaries that were not subject to time limits before. 26 U.S.C. §401(a)(9)(H)(ii). These news rules are intended to both speed up the payment of taxes on distributions from traditional IRAs and also limit the amount of tax-free growth of assets in Roth IRAs.
There remains five categories of beneficiaries called “eligible designated beneficiaries” that are still permitted under the SECURE Act to take distributions from inherited IRAs based on the beneficiary’s life expectancy. These categories are:
- SURVIVING SPOUSE (26 U.S.C. §401(a)(9)(E)(ii)(I)): Surviving spouses can still distribute over their own life expectancies and the right to make rollovers from traditional IRAs into their own retirement accounts is unaffected.
- MINOR CHILDREN OF ACCOUNTHOLDER (26 U.S.C. §401(a)(9)(E)(ii)(II)): However, a minor child of the accountholder “shall cease to be an eligible designated beneficiary as of the date the individual reaches majority and any remainder of the portion of the individual’s interest to [the inherited IRA] shall be distributed within 10 years after such date.” 26 U.S.C. §401(a)(9)(E)(iii).
- DISABLED INDIVIDUALS (26 U.S.C. §401(a)(9)(E)(ii)(III)): “[A]n individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.” 26 U.S.C. §72(m)(7).
- CHRONICALLY-ILL INDIVIDUAL (26 U.S.C. §401(a)(9)(E)(ii)(IV)): The term “chronically ill individual” means any individual who has been certified by a licensed health care practitioner as being unable to perform (without substantial assistance from another individual) at least 2 activities of daily living [for an indefinite one which is reasonably expected to be lengthy in nature due to a loss of functional capacity, having a level of disability similar (as determined under regulations prescribed by the [IRS} in consultation with the Secretary of Health and Human Services) to the level of disability described [above], [and] requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.” 26 U.S.C. §7702B(c)(2).
- INDIVIDUALS NOT MORE THAN 10 YEARS YOUNGER THAN ACCOUNTHOLDER (26 U.S.C. §401(a)(9)(E)(ii)(V)).
“The determination of whether a designated beneficiary is an eligible designated beneficiary shall be made as of the date of death of the [accountholder].” 26 U.S.C. §401(a)(9)(E)(ii)
The SECURE Act of 2019 also prohibits tacking eligible designated beneficiaries to extend the distribution period. An IRA must be distributed within ten years after the death of the first eligible designated beneficiary. 26 U.S.C. §401(a)(9)(H)(iii). For example, if a surviving spouse holds an inherited IRA instead of making a spousal rollover and then dies after designating a disabled or chronically-ill beneficiary, then that beneficiary would have only ten years to distribute the funds.
A beneficiary who fails to liquidate the inherited IRA within the period of time provided under the SECURE Act of 2019 can be liable for a penalty of 50% of the undistributed amount.
INHERITING AN IRA CAN HAVE TAX CONSEQUENCES, BUT OUR SKILLED LAWYERS AND TAX PROFESSIONALS ARE HERE TO ADVISE YOU
If you are the beneficiary of an IRA account, should you take a lump sum or take distributions over a period of time? Are you subject to the five-year rule, ten-year rule or distributions over your lifetime under the SECURE Act? What is the best way to minimize the tax consequences of your inherited IRA, if any? Our law office can answer your questions and guide you in the right direction.
If you have further questions regarding the taxation of IRA accounts, then do not hesitate to contact the experienced attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.