Many people assume they can leave an inherited retirement account alone and withdraw when it’s convenient, but the IRS has a different plan in mind. Depending on your beneficiary category and when your loved one passed away, you may be required to take annual distributions, or face a forced full withdrawal in a single year that could cost a pretty penny in taxes. We’ve broken it down simply, so you can make confident decisions.
Transcript
Inherited IRA rules are… a lot. Unfortunately, they didn’t ask for my input when writing the laws around them because if they had I might have gently suggested they tone down the complexity a bit, but, alas, here we are.
When you don’t understand the exact rules around inherited IRAs, you can run into costly mistakes.
So this video is here to help you understand them better and hopefully keep more of what you’ve inherited.
Because this topic is so nuanced, I’m splitting this into two parts. In my next video, I’ll go over the rules for spouses, but this video is for you if you have inherited a retirement account from someone other than a spouse, perhaps from a parent or through a trust.
My goal is that by the end of this video, you’ll know which category of beneficiary you fall into and what rules apply in your situation. I’ll do this in three steps.
Step one, I’ll explain the different categories of beneficiaries and which category you’re in.
Step two, we’ll discuss timing and how the date of your loved one’s passing impacts your responsibilities.
Step three, I’ll help you understand your withdrawal requirements based on the previous two so you can keep more of what you’ve inherited and send less to the IRS.
I’m Rachael Bourke. I’m a financial advisor with Hello Inheritance. We are a family owned and operated firm where we help women and couples navigate the world of inherited wealth.
Before Diving In
Now, before we get started, I need to make a couple of things clear.
First, this video only applies to folks who have inherited IRAs from those who passed away in or since the year 2020.
Additionally, it’s important to note that these rules apply to IRAs, 401(k)s, 403(b)s, and 457(b)s.
Finally, anytime I talk about withdrawal requirements in this video, I’m referring to Required Minimum Distributions, or RMDs.
The IRS requires that retirement account owners start taking annual distributions at a certain age or after inheritance and, since those accounts were funded with pre-tax dollars, every dollar taken out is taxed as ordinary income.
Now we can get started.
Step 1. Determining Your Beneficiary Category
The first step is to determine which category of beneficiary you fall into.
Category #1: Non-Spouse Beneficiaries
The first category is the most straightforward: Non-spouse Beneficiaries.
This is typically adult children or grandchildren of the deceased. In legal speak, this is called a “Designated Beneficiary” or “Non-eligible Designated Beneficiary.”
Category #2: Eligible Designated Beneficiaries
The second is a bit more nuanced.
Eligible Designated Beneficiaries, or EDBs, include minor children, disabled or chronically ill individuals, and beneficiaries who are no more than 10 years younger than the deceased, perhaps a sibling.
Category #3: Non-designated Beneficiaries.
This includes most trusts, charities, and estates. We won’t go into this topic in too much depth today, but we’ll cover the basics.
Step 2. Timing and Required Beginning Dates
The Required Beginning date is the date that your loved one would have had to start their own Required Minimum Distributions. Okay, let’s back up for a moment.
Required Minimum Distributions, or RMDs, are mandatory withdrawals from certain retirement accounts, including IRAs and 401(k)s.
RMDs must begin at a specified age or after inheritance. So the question at hand is, did your loved one pass away before or after they were required to start distributions? The laws vary depending on the year the deceased was born.
(There’s a graph at minute 03:48 to help you determine what age your loved one was required to start RMDs.)
Important Note!
Before we move on, there’s one important detail you need to note.
If the original account owner passed away after their Required Beginning Date, but before taking their RMD for that year, you as the beneficiary are responsible for taking it. If you don’t, the IRS can impose a penalty of up to 25% of the amount that should have been withdrawn.
And you have to do that by December 31st of the year they passed away.
The financial institution where the account is held should be able to help you with that.
Step 3. Withdrawal Requirements
This is where we will really be digging into the details, so stick with me. I’ll do my best to keep it clear.
You should know by now which beneficiary category you fall into.
Category #1: Non-spouse Beneficiaries
If you are a Non-spouse Beneficiary, such as an adult child, you are subject to the 10-year rule.
Okay, you’re probably wondering, what is the 10-year rule? I am so glad you asked.
The 10-year rule stipulates that the entire account must be emptied by December 31st of the 10th year following the original owner’s death.
However, there’s a nuance.
This is where the “Required Beginning Date” comes in.
If the original owner passed away before their Required Beginning Date or RBD, then you are not required to take annual distributions from the account. You simply have to make sure it’s emptied by the end of the 10th year following their death.
But if they passed away after their RBD, this is important:
You must take annual distributions from this inherited IRA, or face pretty hefty penalties.
One way to think about this is if the original account owner would have already been required to take RMDs, (Required Minimum Distributions), then you must continue that. However, if they were not yet taking RMDs, you don’t either. But either way, you have to deplete the account by the end of the 10th year following their death.
Side Note: Where Planning Can Help
So those are the rules, but now I’m going to put my financial planner hat on.
Here’s where people get into trouble.
Let’s say you inherit a $500,000 IRA. If you take very little out, say just the very minimum required per year or maybe take nothing out and wait until the 10th year, you could be forced to take out hundreds of thousands of dollars in a single year on top of any salary or spouse’s income or any other income you may have.
And remember, every dollar you take out is taxable as income. Just like that, you’ve pushed yourself into a much higher tax bracket. This is sometimes avoidable, but very common.
And this is where planning comes in. Instead of winging it, we help clients map this out ahead of time.
For example, if you inherit the account at 62 and plan to retire at 65, we might keep withdrawals low while you’re still working and your income is already high, then intentionally take more out in those lower income years after retirement and before starting Social Security.
Same account, same rules, but completely different outcomes in terms of dollars in your pocket just based on timing.
Category #2: Non-spouse Eligible Designated Beneficiaries
Okay, let’s move on to Non-spouse Eligible Designated Beneficiaries. As a reminder, this includes minor children, individuals who are disabled or chronically ill, and beneficiaries who are no more than 10 years younger than the original account owner.
If this is you, you are not stuck with the 10-year rule. Instead, you can take annual required minimum distributions based on your own life expectancy, similar to what used to be called a “Stretch IRA.”
This means you can spread withdrawals out over your lifetime while the remaining balance continues to grow without taxes.
Remember, there are always exceptions to the rules, so make sure to talk to a professional about your situation to avoid costly mistakes.
Category #3: Non-designated Beneficiaries
Now, let’s talk about the final category: Non-designated Beneficiaries. This includes most trusts, charities, and estates.
The IRS treats these very differently than an individual person. In many of these cases, the account falls under what’s called the five-year rule. That means the entire account has to be emptied within five years, and as you can imagine, this can create a tax problem.
Even though you’re not required to take annual distributions, in most cases you probably should in order to spread out the tax burden rather than taking it all in that final year.
And here’s something a lot of people don’t know. This is what can happen if no beneficiary is named on a retirement account. In this case, the account typically goes to your estate and is subject to these Non-designated Beneficiary rules.
Now, there is an exception here for certain see-through trusts, which can be treated more favorably, but that gets into estate planning territory, so I’ll leave the nitty gritties to the attorneys.
FAQs
Before we wrap up, I want to take a quick second to answer the questions we get most often about inherited retirement accounts.
Q. Can I do a Roth conversion with my inherited IRA?
A. I wish, but no. It would be a great strategy if it were allowed, but the IRS closed that door.
Q. Can I gift this inherited IRA to a family member who’s in a lower tax and have them take the distributions?
A. Again, no. The account has to stay in your name as the beneficiary. There’s no transferring or retitling an inherited IRA to someone else.
Advanced Tip: You may be able to ‘disclaim’ the account within 9 months. Consult a professional.
Q. Can I use this account for charitable distributions?
A. If you’re over the age of 70 1/2, you can make what’s called a Qualified Charitable Distribution or QCD directly from your inherited IRA to a qualifying charity. This avoids you being taxed on the distribution, but you’ll want to contact your financial institution to set that up properly.
Q. Do these rules apply to inherited Roth IRAs?
A. Generally, yes, the same distribution rules do apply, as the 10-year rule, the annual RMD requirements, if the original owner passed after their required beginning date, etc.. The big difference is that withdrawals from an inherited Roth IRA are mostly tax-free.
I say ‘mostly’ because if the Roth account was less than five years old at the time of the original owner’s passing, the earnings portion could be taxable, but for most people inheriting a Roth, the tax burden is minimal or nothing compared to a traditional IRA.
The Gist
I know we covered a lot today and I want to be honest with you. Inherited IRA rules are genuinely one of the most complex areas of inheritance planning. The SECURE Act made a lot of changes and the details really do matter. Getting them wrong can lead to significant penalties or large tax bills.
So let’s do a recap of what we’ve covered.
Step one, know your beneficiary category. Are you a non-spouse beneficiary, an eligible designated beneficiary, or a non-designated beneficiary? That one answer shapes everything else.
Step two, understand the required beginning date. Did your loved one pass away before or after they were required to start taking distributions?
And step three, know your withdrawal requirements. If you’re subject to the 5- or 10-year rule, have a plan for how to take those distributions rather than waiting until the final year and getting hit with a massive tax bill all at once.
If you need help navigating the complexities of inheritance, investing, and financial planning, reach out to us at HelloInheritance.com. And if this was helpful, subscribe for more videos like this.
See you next time!
Disclosures
This content is for educational purposes only and is not specific investment advice. Advisory services for Hello Inheritance are offered through Bourke Wealth Management. Please visit www.bourkewealth.com for important investor information.
Bourke Wealth Management is a registered investment adviser. Advisory services are only offered to clients or prospective clients where Bourke Wealth Management and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Bourke Wealth Management unless a client service agreement is in place.
This commentary reflects the personal opinions, viewpoints and analyses of the Bourke Wealth Management employees providing such comments, and should not be regarded as a description of advisory services provided by Bourke Wealth Management or performance returns of any Bourke Wealth Management client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Bourke Wealth Management manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.