Tax Day Countdown: Rules You Need To Know Regarding Inherited IRAs
Written by
John Csiszar
Edited by
Amber Barkley
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Few people would complain about receiving an inheritance, including one in the form of an IRA. However, if you do inherit the retirement plan of a loved one, there are some rules you have to follow because, as is always the case with the IRS, nothing in life is tax-free.
Now, with the added time crunch of the tax deadline approaching rapidly, you’re going to want to get your house, and inheritance, in order to avoid a bigger tax bill. And if you don’t adhere to the rules, you could face even more severe penalties.
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What Must You Do If You Inherit an IRA?
If you’re the non-spouse beneficiary of an IRA, you essentially have two options.
The first is to open your own, separate inherited IRA account. Upon providing proper documentation, including a death certificate, you can have the assets transferred into this new inherited IRA account. Note that you are not allowed to transfer the assets into an existing IRA account, if you have one.
The second option is to take a lump sum distribution. This means that you take the full amount of your inheritance from the original account owner in cash and do not put it into an IRA. If you inherit a traditional IRA, this can create serious federal or state income tax consequences.
In most cases, you’ll have to pay ordinary income tax on the full amount of the distribution. Depending on the size of the account, this may even kick you up into a higher tax bracket, causing you to lose even more of your inheritance.
How Have Distribution Rules Changed?
Before 2020, if you inherited an IRA, you weren’t required to take your first distribution until December 31 of the year after the original account holder died. From there, you were required to take annual distributions based on your life expectancy. This allowed beneficiaries to spread out the tax hit over their entire lifetimes.
However, things changed in 2020. Now, there’s a 10-year rule in effect for inherited IRAs. Eligible designated beneficiaries or non-spouse beneficiaries must withdraw the entire amount of an inherited IRA within 10 years. This results in a larger tax obligation over a shorter period. It also results in less time to allow assets to grow tax-deferred within the account, which only escalates the stress for any filing deadline.
Imagine, for example, that you’re a 40-year-old and you inherit an IRA. Under the old rules, you could slowly distribute that IRA over 30, 40 or even 50 or more years, growing the remaining balance on a tax-deferred basis as you wait and paying minimal taxes. But thanks to the changes that went into effect in 2020, you’ll now have to drain that IRA within 10 years, accelerating your tax liability.
Note that if you inherit a Roth IRA, you won’t generally have to pay taxes on your required minimum distributions (RMDs). However, if the original account was open for less than five years, you may still have a tax liability, per the IRS.
Rules Are Different If You Are the Spouse of the Decedent
If you’re a non-spouse beneficiary of an IRA, you must create a new inherited IRA and transfer the money into it. But if you’re the spouse of a decedent, making you a spousal beneficiary, you have two options: You can either create a new inherited IRA or you can simply roll the decedent’s IRA into your own, existing IRA.
Perhaps more importantly, spouse beneficiaries are not subject to the 10-year mandatory distribution rule. Rather, you’re allowed to distribute the IRA according to your own original schedule. For a traditional IRA, this means you can take distributions over your lifetime, rather than over 10 years. For a Roth IRA, no mandatory distributions are required, so you can keep the money in your account for as long as you desire.
Caitlyn Moorhead contributed to the reporting for this article.
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