An IRA can be a wonderful account to inherit. However, the rules are complex, and errors can be costly. There are some great tax advantages if you handle your inheritance correctly. Unfortunately, there can potentially be a big tax bill if you do not. Follow these steps to avoid a few common mistakes and help to maximize the benefits of your new inheritance.
1. Determine if you are a Eligible designated beneficiary, non-eligible designated beneficiary, or non-designated beneficiary.
Prior to 2020, if you were named as a beneficiary of an IRA, you were able to stretch distributions over the course of your remaining life expectancy. These rules still apply for all designated beneficiaries who inherited IRAs before January 1, 2020. However, the SECURE Act, which was passed into law in 2019, changed these rules. Now, anyone who is a designated beneficiary and inherits an IRA after December 31, 2019 will be classified as an eligible designated beneficiary or a non-eligible designated beneficiary.
Eligible designated beneficiaries include surviving spouses, certain minor children, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the decedent. For these beneficiaries, the old rules still apply, and they are generally able to stretch distributions over their remaining life expectancy.
All other named beneficiaries are considered non-eligible designated beneficiaries and must empty the account within 10 calendar years—a time period that starts the year after the death of the original owner. For more information on strategies for non-eligible beneficiaries subject to the 10-year rule, see this blog post. It is also possible that the IRA’s original owner may have named their estate as beneficiary, which means that an heir would not inherit the IRA directly, but through the deceased’s will. In this case, the beneficiary would be considered a non-designated beneficiary and the following rules would apply. Read why this is usually not a good option here.
- If the original IRA owner has not reached the date of their first required distribution after age 73, the heir must empty the account using the five-year rule. All funds must be distributed to the beneficiary by the end of the fifth year after death.
- If the original owner dies after starting post-73 distributions, the heir can take minimum distributions based on the deceased owner’s age at the time of death. The payout period using this method could be as long is 15.5 years (based on life expectancy of someone who died at age 73). The older the IRA owner, the shorter the distribution period available to the non-designated beneficiary.
2. Ascertain if you are the sole beneficiary, or if the IRA is shared with others.
It’s common to name more than one person as the beneficiary of an IRA. Each beneficiary must set up their own inherited IRA account and abide by the rules that apply to their beneficiary type. There is a deadline for splitting the IRA. Keep these two dates in mind:
- September 30 of the year after the account owner’s death: Designated beneficiaries must be determined.
- December 31 of the year after the account owner’s death: The split of the inherited IRA must be completed.
3. Title the new IRA correctly
Setting up the inherited IRA correctly is an important step. Inherited IRAs must contain the name of the original IRA owner (the deceased) and indicate that the IRA is inherited. For example, John Doe Jr. Beneficiary IRA, John Doe Sr. deceased 6/1/2020. Only the spouse of the deceased can roll over an inherited IRA into their name. Otherwise, an inherited IRA must always be kept as a separate account.
4. Name your beneficiary
Part of the process of setting up an inherited IRA should include naming your beneficiary for the account. If an heir taking stretch distributions dies before emptying the inherited IRA account, two rules apply to the successor beneficiary depending on when the original beneficiary inherited the account:
- If the original beneficiary inherited the IRA before January 1, 2020 and was taking distributions based on life expectancy, then the successor beneficiary will have 10 years to empty the account starting the year following the original beneficiary’s death.
- If the original beneficiary inherited the IRA after December 31, 2019 and is thus subject to the 10-year rule, then there is no additional 10-year period granted for successor beneficiaries. Once the 10-year payout date is determined by the death of the original owner, it is locked in, and both the original beneficiary and all successor beneficiaries must abide by that timeline.
5. Calculate the correct distribution amount
For post 2020 designated beneficiaries (and beneficiaries who inherited IRAs prior to 2020), annual distributions are required. In order to calculate these required distributions, two pieces of information will be needed: the prior year-end account value and life expectancy.
- Year-end value: To determine a minimum distribution, use the account value as of the end of the prior year. For example, distributions for 2023 will use account values as of December 31, 2022. The first distribution is required from an inherited IRA by December 31 of the year following the year of death. The account may not have been split at the prior year-end. In that situation, the account value is divided by the percentage the heir has inherited.
- Life expectancy: The table used for non-spouse beneficiaries is the Single Life Expectancy Table found in IRS Publication 590‑B. The heir will find their age in the year after the IRA owner’s death. This only needs to be done once. Each year after that, the heir will subtract one from the prior year’s factor.
6. Determine any after-tax basis in the IRA
The after-tax basis is often overlooked in an inherited IRA. Beneficiaries of IRAs with after-tax contributions need to file Form 8606 to claim the non-deductible portion of their required minimum distribution. Many beneficiaries never bother to determine if the IRA they inherited has an after-tax basis. The executor may not know unless they go back through the deceased’s tax returns to determine if Form 8606 had been filed in earlier years. IRA beneficiaries should ask about after-tax contributions and research past tax returns if necessary.
7. Plan for the taxation of distributions
Roth IRAs: A five-year period began with the original Roth IRA owner’s first Roth conversion or contribution. Part of the heir’s distribution attributed to earnings could be taxable if the five-year period for qualified distributions was not satisfied. Fortunately, the IRS ordering rules say earnings come out last and the five-year period does not start over for the beneficiary. Before taking any large distributions from the inherited Roth IRA, beneficiaries should find out when the original account was opened and how much of the current account value is deemed to be earnings so they can determine whether a portion of the distribution will be taxable.
All other IRAs: Distributions from a traditional IRA, SEP IRA, or SIMPLE IRA will be fully taxable—unless the IRA owner had a tax basis in their IRA. Step six explained how to determine whether there is any tax basis. Step five explained how to calculate the amount of the distribution. Add the taxable portion of the distribution to a tax projection for the year to determine how much tax to withhold.
Note that the 10% early withdrawal penalty for those under age 59.5 never applies to distributions from inherited traditional or Roth IRAs. Distributions due to death is one of 10 penalty exemptions for early distributions. Talk to a knowledgeable adviser, preferably an experienced retirement adviser, if you receive notice that you will be inheriting an IRA. A mistake could mean the loss of the ability to take stretch payments—or worse, a large tax bill on your inheritance.
- Eligible designated beneficiaries can stretch distributions over their life expectancy. Non-eligible designated beneficiaries are subject to the 10-year rule. Non-designated beneficiaries must use the five-year rule.
- Multiple IRA beneficiaries must split the IRA, and different rules may apply to each beneficiary depending on their beneficiary type.
- Roth IRA beneficiaries should understand the five-year rule to avoid potential income tax on the earnings portion of an inherited Roth IRA.
Originally posted August 2017