7 Steps to Take When You Inherit an IRA - Rodgers & Associates
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7 Steps to Take When You Inherit an IRA

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 72, 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-72 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 72). 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 non-eligible desig­nated benefi­ciaries, no annual distri­b­ution is required. The only requirement is that the account must be emptied at the end of the 10-year period. But for eligible 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 2021 will use account values as of December 31, 2020. 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.

Rick’s Tips:

  • 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