Congratulations Gen Xers and millennials. The “Great Wealth Transfer” is on. Baby boomers are expected to pass on upwards of $30-$40 trillion in assets over the next 25 years, according to Cerulli Associates.
Many of these assets will be given in the form of an IRA or 401(k), which beneficiaries can turn into their own inherited IRAs.
An inherited IRA is an account that is opened when an individual inherits an IRA or employer-sponsored retirement plan after the original owner dies. Additional contributions may not be made to an inherited IRA.
The good news is, as the beneficiary, an inherited retirement account could be a great source of money to help fund your financial goals. The downside, however, is that if you’re not the spouse of the original account owner, there are strict rules to navigate. One wrong move could result in paying more in taxes and/or penalties.
Here’s what non-spouse individuals should know.
10-Year Rule for Inherited IRA Non-Spouses
Before the SECURE Act passed in 2019, non-spouse beneficiaries were able to inherit a retirement account, transfer it into an inherited IRA, and then withdraw money from it over their lifetimes.
Under the new law, non-spouse beneficiaries are now required to withdraw all the funds within 10 years of the original account holder’s death. You can make withdrawals when desired -- either all at the beginning, in equal installments or all at the end of the 10-year period.
Still, the shorter window in which beneficiaries must deplete the account could result in unwanted tax bills, if not properly addressed. Therefore, those who stand to inherit an IRA and those who want to hand one down should plan carefully.
Inherited IRA Non-Spouse Exceptions
There are exceptions to the 10-year rule for eligible designated beneficiaries (EDBs). They include: minor children (not grandchildren) of original owner (10-year clock begins once minor child of original owner reaches age of majority); beneficiaries less than 10 years younger than original owner; and those disabled/chronically ill (as defined by the IRS).
In general, if you’re eligible to stretch distributions as a spouse or eligible beneficiary, doing so makes sense because it allows you to take advantage of the tax deferral.
Inherited IRA Tax Rules by Account
Tax rules can also vary depending on the type of account you inherit.
For example, withdrawals from inherited traditional IRAs and employer-sponsored accounts are taxed as ordinary income. Unless you are an EDB, the 10-year applies. Therefore, depending on your tax situation, it may be advantageous to withdraw assets in equal installments over the entire 10-year period, as it helps smooth out the impact of additional taxable income and help lower the risk of bumping you into a higher marginal tax bracket by mistake.
Meanwhile, withdrawals from an inherited Roth IRA are not taxed, as long as the account has been open for at least five years. The 10-year rule will also apply if you are not an EDB. In this case, it may make sense to keep assets in inherited Roth accounts for as long as possible to help you earn your highest returns because qualified withdrawals are tax-free.
Withdraw money as a lump sum
Instead of opening an inherited account, you can take all of the money in one lump sum. But you must consider the tax consequences.
The money is first placed in an Inherited IRA and then you can choose to withdraw the entire balance. This may be considered a taxable distribution depending on the type of IRA (Traditional or Roth) inherited and how the contributions were made (pre-tax or after-tax). A large taxable withdrawal that is taxed as ordinary income could move you into a higher tax bracket.
What about Inherited IRA RMDs?
The IRS requires you to start withdrawing a minimum amount of money each year from most retirement accounts once you reach the age of 72. These are called Required Minimum Distributions (RMDs). When it comes to an inherited account for non-spouse beneficiaries, rules for RMDs do not apply because of the 10-year rule.
When it comes to an inherited retirement account there are many options to consider before you take ownership and use the money. And, the rules change depending on your relationship to the account holder and the type of account you inherit.
You can learn more about your options by reading our free Guide to Inherited Retirement Accounts.
Whether you’re a spouse, family member, friend or trustee, this guide shows you the various options available to you as an IRA beneficiary so you can make the right decision.