Inherited an IRA? Here's What You Need to Know

Technically titled a Beneficiary IRA, this is an account created when someone inherits retirement assets from a deceased owner. Mistakes in withdrawals and management can result in unnecessary taxes or penalties. 

In this article, I will define what Beneficiary IRA is, highlight key requirements, and discuss some typical examples of the different beneficiary situations. 

What Is a Beneficiary IRA?

A loved one passes—and leaves you their IRA. When this happens, you must open a Beneficiary IRA. Types of beneficiaries vary as any person or entity can inherit an IRA except for a minor or pet. This means spouses, friends, trusts, estates, charities — all are eligible. 

But a Beneficiary IRA has its own set of restrictions and tax obligations depending on who inherits it. There’s also a minor difference between inheriting Traditional and Roth IRAs. This main difference is that Traditional IRA income remains taxed as income while Roth IRAs are tax-free. 

The Core Rules (Post-SECURE Act)

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in 2019, sets specific rules for Beneficiary IRAs. Spouses, for example, have the most flexibility. They can treat their inherited IRA as their own or they can remain a beneficiary. Non-spouse recipients have stricter guidelines. 

Originally, for “eligible designated beneficiaries” like minor children, disabled or chronically ill individuals, or beneficiaries less than 10 years younger than the deceased, withdrawal limits are based on life expectancy stretch rules. This means that beneficiaries can use their own life expectancy to determine Required Minimum Distributions (RMDs). However, this changed in the 2022 update under SECURE 2.0. Non-spouse beneficiaries must now withdraw the entire amount within 10-years. For minor children, the 10-year clock begins when they reach 21.

Everyone else, usually adult children and other individuals, uses the 10-year rule. Like with non-spouse beneficiaries, all funds must be withdrawn within 10 years.

For estates, trusts, and charities, that time-period may be reduced to only 5-years.

Why Beneficiary IRAs Are So Challenging

For most beneficiaries, the real challenges relate more to taxes and tax mitigation than the IRA itself. Because all non-spouse beneficiaries must withdraw the entire amount in a short amount of time. As a result, one must often weigh the consequences of lump-sum versus spread-out withdrawals and its impact on their tax bracket.

To confuse matters further, deadlines and penalties for missteps, such as excise taxes on missed RMDs, can further eat into your inheritance. 

Three Real-World Examples

What does all of this look like in practice? Let’s consider three different beneficiaries and how the rules apply. In these cases, all of the Beneficiary IRAs had a designated beneficiary and that the IRA was retitled appropriately. 

1. The Spouse: A surviving spouse rolls inherited IRA worth $3 million into their own account. They can treat this inheritance as a part of their regular IRA, there is no time limit to take the money out.
   
   
2. The Adult Child: An adult child is a non-eligible designated beneficiary under the 10-year rule. They receive $3 million dollars, and must weigh when to take distributions to minimize taxes. There are many ways to mitigate taxes depending on an individual’s income bracket and current assets. In this case, the adult child decides to spread out withdrawals to mitigate taxes and improve tax deferment gains. They use these funds to max out a new Roth IRA and fund a High Yield Savings Account.
   
   
3. The Minor Child: A 14-year-old inherits $3 million in an Beneficiary IRA. It is from their parents, not grandparents, so this child is still considered an eligible designated beneficiary using stretch provisions. When they turn 21, the IRA withdrawals will convert to the 10-year rule. 

Decoding Your Inheritance

Beneficiary IRAs aren’t necessarily simple, and they require planning to minimize tax obligations, avoid penalties, and maximize savings These rules depend heavily on who you are relative to the deceased, your tax bracket, and your age.

It can be helpful to work with an objective finance professional who understands the ins and outs of retirement accounts. Whether it’s your current advisor, your tax consultant, or another trusted professional, it’s important to incorporate knowledgeable advice into your financial plan. 

And if you’re looking for a second opinion, I’m always happy to jump on a no-commitment discovery call and see if we’re a good fit.

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