When individuals inherit an individual retirement account (IRA) from a parent, they must navigate specific rules to manage the account properly. Understanding these rules is crucial for maximizing the inherited funds and minimizing tax implications. This article outlines the necessary steps for beneficiaries to take following such an inheritance.
Setting Up an Inherited IRA
Inheriting an IRA involves more than merely transferring the funds into a personal account. Generally, beneficiaries cannot roll an inherited IRA into their own IRA unless they are the spouse of the deceased. Instead, the funds must be transferred into a newly established inherited IRA, which should be titled under the deceased owner’s name. For example, it would read: John Smith, deceased, for the benefit of Jane Smith.
If multiple beneficiaries are named, the IRA can be split into separate inherited accounts, enabling each beneficiary to manage withdrawals independently. Most banks and brokerage firms offer the option to open an inherited IRA, with many suggesting that beneficiaries set it up with the firm that held the original account for ease of management.
Understanding the 10-Year Withdrawal Rule
According to the SECURE Act, enacted in December 2019, most non-spousal beneficiaries must withdraw the entire amount from an inherited IRA within ten years following the original owner’s death. This rule applies to accounts where the owner passed away in 2020 or later. If the deceased had initiated required minimum distributions (RMDs) before their death, the beneficiary must continue taking annual RMDs while ensuring the account is emptied by the end of the ten-year timeframe.
Conversely, if the original owner had not started to take RMDs, there is no requirement for annual withdrawals, provided that the entire IRA is depleted by the end of the ten-year period. Beneficiaries can opt for faster withdrawals, but it is essential to note that distributions from a traditional IRA are subject to ordinary income tax in the year they are taken. Withdrawals from a Roth IRA are typically tax-free, provided the account has been active for at least five years.
Failure to take an RMD or withdrawing insufficient amounts can result in a hefty penalty, which stands at 25 percent of the amount that should have been withdrawn. This penalty can be reduced to 10 percent if the error is rectified within two years.
Exceptions to the Withdrawal Rule
Several beneficiaries are exempt from the ten-year rule, including surviving spouses, minor children, disabled or chronically ill beneficiaries, or individuals who are within ten years of age of the original IRA owner. These exceptions may allow for longer withdrawal periods, providing additional flexibility in managing the inherited funds.
Tax Implications and Strategic Withdrawals
While it may be tempting to cash out an inherited IRA or take significant withdrawals over a short period, such actions can lead to substantial tax liabilities. Withdrawals from traditional IRAs are taxed at the beneficiary’s regular income tax rate. For many, spreading distributions over the ten-year period can help manage tax exposure and avoid moving into a higher tax bracket.
Given the complexities surrounding inherited IRAs, beneficiaries are encouraged to consult with a financial adviser. Professional guidance can help navigate the specific rules and make informed decisions regarding withdrawals and tax planning.
