In our last post on retirement planning, we discussed the IRS’ proposed changes to the payout structure of inherited IRAs, which would go against the provisions of the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act).
Today, we are going to discuss the existing rules – the three categories of beneficiaries, and the payout rules applicable to each category, as provided by the SECURE Act and existing IRS rules.
Eligible Designated Beneficiaries:
An eligible designated beneficiary can be any of the below:
- The deceased account owner’s spouse.
- A disabled beneficiary.
- A chronically ill beneficiary.
- A beneficiary not more than 10 years younger than the deceased account owner.
- A minor beneficiary who is the child of the deceased account owner (the 10-year distribution rule will only become effective when the beneficiary reaches the age of majority).
Some options are available only to a surviving spouse:
For traditional IRAs (including rollover IRAs, SEP IRAs, and SIMPLE IRAs)
- Spousal Transfer. A surviving spouse who is the original account owner’s sole beneficiary can treat the account as his or her own, rolling it into an existing IRA, or setting up a new one. Assets will continue to grow on a tax-deferred basis, and can be available at any time – subject to the 10% penalty for withdrawals made by the new account owner if under 59½ at the time of the withdrawal. The new account owner must designate his/her own beneficiary.
- Open an Inherited IRA – Life Expectancy. Opening an Inherited IRA in the beneficiary’s name is available to all eligible designated beneficiaries, with one significant provision for surviving spouses alone, if the original account owner was under the age of 72 at the time of his/her death. In this case, required minimum distributions (RMDs) can be deferred until December 31 of the year in which the original owner would have turned 72. These RMDs are based upon the life expectancy of the new account owner, and are not subject to penalty, no matter the age of the surviving spouse. The surviving spouse need not be the sole beneficiary of the original account, but if there are more beneficiaries than him/herself, separate accounts for all beneficiaries must be established by December 31 of the year following the year of death in order for the spouse to be able to elect distributions based on his/her life expectancy. Otherwise, distributions will be based upon the life expectancy of the oldest beneficiary.
For Roth IRAs, both the spousal transfer and inherited (Roth) IRA options remain – but if the surviving spouse transfers the Roth IRA into his/her own IRA rather than into an inherited IRA, the assets must be held for five years and until the new owner turns 59½ before tax- and penalty-free withdrawals can be made.
For non-spousal eligible designated beneficiaries – though surviving spouses can elect these as well, the options for traditional IRAs are:
- Inherited IRA – Life Expectancy. If the original account owner died before reaching age 72, RMDs will be based upon the beneficiary’s life expectancy, determined by his or her age at the time of the account owner’s death and reevaluated yearly. RMDs must be taken annually, beginning no later than December 31 of the year following the death; these withdrawals are taxable, and are not subject to the 10% early withdrawal penalty. However, if the original account owner was 72 or older at the time of his/her death, RMDs can be based upon the deceased’s life expectancy, if longer than the beneficiary’s (if the deceased did not take an RMD in the year of death, an RMD must be taken by December 31 of that year). Note that for an eligible designated beneficiary who is the minor child of the deceased, the life-expectancy option ceases to be available when the child reaches majority – at that point, the beneficiary must switch to the 10-year method (see below).
- Inherited IRA – 10-Years. At present, the assets transferred into the Inherited IRA under the 10-year method are not subject to RMDs. However, all assets held in the Inherited IRA must be distributed by December 31 of the 10th year following the original account owner’s death. Distributions are taxable, but are not subject to the 10% early withdrawal penalty. Note that this option is not available to eligible designated beneficiaries if the original account owner was over 72 at the time of death.
- Lump Sum Distribution. Any eligible designated beneficiary of a traditional IRA can elect to have the entire account (or their portion of it) distributed to them without transferring the assets first. The distribution is taxable, but not subject to the 10% penalty.
For inherited Roth IRAs, all three options above are available:
- Inherited Roth IRA – Life Expectancy. With this option, RMDs are mandatory; these distributions must be taken beginning no later than December 31 of the year after the year of the original account owner’s death. The RMDs are spread over the life expectancy of the beneficiary. In the case of a minor child, this option is available only until the child reaches majority, at which point the beneficiary must switch to the 10-year option. In the case of multiple beneficiaries, again, separate accounts must be established for all beneficiaries by December 31 of the year following the original account owner’s death in order for beneficiaries to use their own life expectancy measure for RMD calculation. If such accounts have not all been established by then, the decedent’s life expectancy will be used to calculate the RMDs.
- Inherited Roth IRA – 10-Year. A beneficiary electing this option is, under current rules, not required to take RMDs, but must fully distribute the entire account by December 31 of the 10th year following the original account owner’s death.
- Lump Sum Distribution. All assets in the Roth IRA will be distributed to the beneficiary. Assuming the assets were held for 5 years or more in the account, distributions will be tax free. Otherwise, tax will apply only to the account earnings, not to the original owner’s contribution amounts.
Note that for beneficiaries inheriting Roth IRAs, providing the assets in the account were held for 5 years or more in the Roth IRA, all distributions are tax free to the beneficiaries. If the holding period is less than 5 years, distributions representing earnings on the original investment(s) are taxable, but withdrawals representing the amounts initially invested by the original account owner remain untaxable. Distributions are also not subject to the 10% penalty.
These beneficiaries are individuals who do not qualify as eligible designated beneficiaries. Certain trusts also qualify as designated beneficiaries, providing the trust is considered a pass-through entity, paying out from the inherited IRA to the trust’s beneficiaries and not holding any of the assets within the trust.
Designated beneficiaries must take distribution of the IRA’s assets no later than December 31 of the 10th year following the original account owner’s death. Distributions from traditional IRAs are taxable but not subject to the 10% penalty. Roth IRA distributions are tax free, provided the assets were held in the original Roth IRA for 5 years or more. If the Roth IRA’s assets were not held for that length of time, again, only distributions on earnings are taxable, not distributions of original investment amounts.
“Not Designated” Beneficiaries:
Generally speaking, these beneficiaries are entities, not individuals. With the exception of pass-through trusts which do not hold any of the inherited IRA’s assets, any non-individual beneficiary, including other trusts, estates, and charitable organizations, is considered “not designated.”
The SECURE Act did not change the rules governing such entities in relation to their inheritance of IRAs:
- Traditional IRAs. For traditional IRAs whose original owner dies before s/he was required to take RMDs, the beneficiary entity must distribute the entire account balance by December 31 of the 5th year following the death. If the account owner was subject to RMDs at the time of death, distributions are made using the decedent’s life expectancy.
- Roth IRAs. All account assets must be distributed by December 31 of the 5th year following the original account owner’s death.
Distributions from traditional IRAs are taxable but not subject to penalty.
Distributions from Roth IRAs are not taxable, providing the original assets were held in the Roth IRA for at least 5 years.
If you intend to leave an IRA or IRAs to beneficiaries, or know you will inherit, and have questions as to how to best structure your planning, please click here to email us directly – let us know how we can help.
Until next time –