Time to Update Your IRA Beneficiaries!

It is essential to familiarize yourself with the revised distribution rules for inherited IRAs following the recent updates in the SECURE Act, particularly with the latest version known as SECURE 2.0.

Wealth is often transferred from one generation to the next through inherited IRAs. Understanding the recent changes in the rules associated with the Setting Every Community Up for Retirement Enhancement (SECURE) Act and its latest version, SECURE 2.0, is crucial when dealing with these individual retirement accounts.

Before diving into the specifics of inherited IRAs, it’s important to note that IRA assets cannot be held indefinitely. The IRS mandates annual withdrawals once the IRA owner reaches the required beginning date (RBD). Prior to the SECURE Act, the Required Beginning Date (RBD) was April 1 of the year following the year the IRA owner turned 70½. The original SECURE Act, effective in 2020, adjusted the RBD to April 1 of the year the IRA owner turns 72, applicable only to those born on or after July 1, 1949. With the enactment of SECURE 2.0, the RBD and required minimum distributions (RMDs) have been further shifted to age 73 for individuals who reached that age in 2023.

All types of IRA owners, including traditional IRAs, SEP IRAs, and SIMPLE IRAs, are required to take the minimum RMD, with the exception of Roth IRA owners. Roth IRAs only impose an RMD requirement upon the death of the original owner when the account is passed on to the beneficiary or beneficiaries.

Confused? You are not alone! Here’s what you should know about inheriting an IRA.

What are the implications of inheriting an IRA from a spouse?

If you have inherited an IRA from your spouse, you have a unique option not available to others, and the recent changes under SECURE 2.0 have not affected this choice. You can combine the inherited IRA assets with your own IRA, allowing for potential growth that can enhance your retirement savings. However, it is essential to note that the IRA types must match; for instance, if your spouse held a Roth IRA, you must transfer the funds into a new or existing Roth IRA under your name.

Integrating the inherited assets into your IRA can help maintain tax advantages, enabling either tax-deferred growth (for traditional IRAs) or tax-free growth (for Roth IRAs). Additionally, by assuming the IRA, you may have the opportunity to make further contributions to bolster your savings. Once you take over the IRA assets, your required minimum distributions (RMDs) will be calculated based on your age—73 as of 2023 or 75 starting in 2033. A key benefit of receiving RMDs from your own IRA, as opposed to an inherited IRA, is that they are typically smaller due to the differing calculation methods for IRA owners and beneficiaries.

After incorporating the inherited assets into your IRA, if you seek tax-free income during retirement or anticipate a higher tax rate in the future, you might consider converting your traditional IRA to a Roth IRA. Be aware that depending on the nature of your spouse’s contributions to their IRA, you may incur taxes on the converted amount. Before proceeding with the conversion, review your spouse’s past tax returns to see if they included Form 8606, which reports nondeductible IRA contributions. Nondeductible contributions are not taxed upon Roth conversion, as taxes on that money have already been settled. If neither your inherited traditional IRA nor your personal traditional IRA contains nondeductible contributions, the entire amount converted to a Roth IRA will generally be taxable in the year of conversion.

Other inherited IRA options for surviving spouses.

Here are additional options available to a surviving spouse regarding an inherited IRA. It’s important to note that the SECURE Act has altered the “stretch IRA” provisions for most non-spouse beneficiaries.

1. Withdraw life expectancy payments from an inherited (beneficiary) IRA.

Instead of consolidating the IRA into your own account, you can choose to re-register it as an inherited IRA in your name. Whether this option is suitable for you depends on the type of IRA you’ve inherited (traditional or Roth), your deceased spouse’s age, and the applicable RMD rules.

As previously mentioned, for assets held in an inherited IRA, the surviving spouse is required to take periodic withdrawals, or RMDs. These distributions represent the minimum amount that must be withdrawn each year, calculated based on the surviving spouse’s life expectancy.

Typically, a surviving spouse who opts for an inherited IRA must use their single life expectancy to determine RMDs. This single life expectancy calculation may result in significantly larger payments compared to what would have been required had the spouse assumed the IRA and used joint life expectancy upon reaching the RMD age. Smaller RMDs are advantageous for maintaining the longevity of your IRA portfolio, especially for those concerned about outliving their funds due to longer life expectancies.

In some situations, it may be beneficial for a surviving spouse to utilize an inherited IRA for a limited duration before assuming the IRA. Therefore, if you are a surviving spouse beneficiary seeking to manage your distributions effectively, it’s advisable to carefully review and compare the required amounts and their timing.

The timing for when a surviving spouse must begin taking RMDs from an inherited account is contingent upon whether the deceased spouse had already reached their required beginning date (RBD) for RMDs prior to their passing.

• If the deceased spouse had reached their RBD, the surviving spouse is required to take any remaining RMDs that the decedent missed for the year of death. Subsequently, the surviving spouse must commence their own RMD life expectancy payments in the year following the year of death, continuing this annually. Naturally, the spouse has the option to withdraw more than the minimum required amount if desired.
• If the deceased spouse had NOT yet reached their RMD beginning date (RBD), the surviving spouse has two options for initiating their life expectancy payments:

1. By December 31 of the year following the death of the original account owner, or, if later.
2. By the end of the year in which the original account owner would have reached their RBD.

Here are several additional considerations regarding inherited IRAs, depending on the type inherited by the surviving spouse:

Traditional Beneficiary IRA: Distributions from a traditional beneficiary IRA are generally taxable; however, the 10% penalty for early withdrawals before age 59½ does not apply. The timing of RMDs is determined by whether your spouse had started taking them at the time of their death, specifically if they had reached their RBD. If the decedent had begun taking RMDs, you must continue those distributions. Additionally, if the deceased spouse did not take their RMD for the year of their death, the surviving spouse is required to withdraw that amount as well. It’s important to remember that there is also a penalty ranging from 10% to 25% for any missed RMDs.

Roth Beneficiary IRA: The RMD rules for inherited Roth IRAs are similar to those for inherited traditional IRAs; however, withdrawals from Roth IRAs are generally tax-free, provided the original account has been funded for five years or more, and any assets withdrawn from converted balances have also been held in the account for at least five years. If the spouse beneficiary prefers not to take these inherited Roth IRA distributions, they may consider rolling over the inherited assets into their own Roth IRA to avoid these payments, as previously mentioned.

2. Opt for a lump-sum or random distribution while ensuring compliance with the 10-year rule.

If you have an urgent need for funds, you may opt to receive a lump-sum distribution from the inherited IRA. However, doing so would forfeit any potential tax benefits associated with keeping the funds in an IRA, such as the opportunity for tax-deferred or tax-free growth. Additionally, if the IRA is a traditional one, you will likely owe taxes on the distribution, which could potentially elevate you to a higher tax bracket for that year.

Should you choose to leave the IRA in your spouse’s name or transfer it into an inherited IRA, keep in mind that you must begin taking periodic RMD withdrawals unless you qualify for and elect to follow the 10-year rule. This rule mandates that all assets in the inherited IRA must be fully withdrawn by the end of the tenth year following the original IRA owner’s death. (For deaths occurring in 2019 or earlier, the rule was a five-year timeframe.) Generally, surviving spouse beneficiaries can wait until the end of the 10-year period to make withdrawals; however, proposed IRS guidance may necessitate annual payments for some beneficiaries starting in 2024. It is advisable to consult a tax advisor before the end of this year to ascertain whether you need to make a withdrawal before December 31, 2024, if you are adhering to the 10-year rule. Remember, failing to distribute the required withdrawals may result in a penalty of up to 25%.

3. Disclaim the inherited assets.

You also have the option to refuse all or part of the inherited assets. By doing so, the remaining assets will be passed on to the next eligible beneficiary. This can be a way to assist someone whose financial situation may not be as secure as yours.

Before the SECURE Act, it was common practice to extend IRA tax benefits to future generations by naming young children, grandchildren, or even great-grandchildren as beneficiaries. However, significant changes were implemented under the SECURE Act for non-spouse beneficiaries of deaths occurring in 2020 or later. Many of these beneficiaries are now required to withdraw all funds by the end of the 10-year period following the death. As a result, most beneficiaries will no longer be able to stretch these payments beyond this 10-year window. Therefore, it’s important to review your beneficiary designations. Note that the decision to disclaim assets typically must be made within nine months of your loved one’s passing.

Before proceeding with any distribution choice, it is advisable to consult with a tax professional who can help you navigate the associated tax implications.

Inherited IRAs for non-spouses.

The SECURE Act abolished the “stretch IRA” option for most non-spouse beneficiaries. Previously, this strategy allowed beneficiaries to use their life expectancy to minimize IRA withdrawals over time, thereby enabling them to shelter a substantial portion of their inheritance from taxes. With the enactment of the SECURE Act, this stretch provision was eliminated for many beneficiaries (although spouses still retain this option), introducing a new 10-year rule that remains in effect under SECURE 2.0.

For deaths occurring in 2020 or later, only specific non-spouse individual beneficiaries, referred to as “eligible designated beneficiaries,” are exempt from the 10-year depletion requirement and may utilize their life expectancy to determine the minimum annual withdrawals. These eligible beneficiaries include:

1. Non-spouse beneficiaries who are chronically ill or disabled.
2. Non-spouse beneficiaries who are no more than ten years younger than the deceased account owner.
3. A minor child of the account owner (either biological or legally adopted), until they turn 21. After reaching 21, the beneficiary has ten years to withdraw the remaining balance from the account.

All other non-spouse beneficiaries are required to adhere to the new ten-year rule for depleting the account. This regulation applies to grandchildren and other relatives who do not qualify under the aforementioned exceptions. Consequently, rather than stretching inherited IRA withdrawals across a lifetime, these non-eligible beneficiaries must fully withdraw the account balance by the end of the tenth year following the account owner’s death.

As a beneficiary, you can choose to withdraw funds from the account more quickly. However, this expedited access comes with the drawback of larger withdrawals, which could substantially increase your tax liability, particularly if the inherited assets are held in a traditional IRA, SEP-IRA, or SIMPLE IRA. Conversely, if the assets are in a Roth IRA, beneficiaries can withdraw funds tax-free, provided the Roth IRA has been funded for at least five years.

It’s also important to note that inherited IRAs are not protected from creditors. While a spouse may be able to shield the assets in an inherited IRA from debt settlements, non-spouse beneficiaries do not enjoy this protection. This is a crucial consideration to keep in mind if you inherit an IRA.

Inherited IRAs and withdrawal regulations for Required Minimum Distributions (RMDs)

If you have inherited a retirement account, you are generally required to withdraw Required Minimum Distributions (RMDs) to avoid IRS penalties. The amount of RMDs is influenced by several factors, including the beneficiary’s age, their relationship to the account owner, and the account’s value. If the inherited assets have been transferred into an inherited IRA under your name, you may find tools available to help you calculate the necessary withdrawals and identify the most suitable distribution method for your situation.

If you are aware that someone intends to leave you an inherited IRA, it is advisable to address financial matters promptly—ideally, even before their passing. Family members should ensure that all paperwork is in order, as incomplete or unclear beneficiary forms can lead to complications later. Notably, if there is a conflict between a beneficiary form and a will, the beneficiary form will take precedence over the will.

For instance, in cases where clear beneficiaries are not designated, the IRA may revert to the estate, which typically activates the five-year rule for mandatory distributions. Under the SECURE Act, non-individual beneficiaries, such as the estate, are subject to the five-year rule for required distributions, provided that the original account owner had not yet reached their RMD age. However, if the original IRA owner reached their RMD age (RBD) and passed away in 2020 or later, the estate may be permitted to take distributions over a period extending beyond the five-year rule. According to proposed IRS regulations, the estate would be required to take annual RMDs based on the deceased IRA owner’s remaining single life expectancy, decreasing by one each year that the assets remain in the IRA.

Conclusion

When deciding how to manage an inherited IRA, it’s essential to carefully evaluate your available options. Consulting with a knowledgeable retirement or tax professional can guide you through these alternatives and help you minimize potential negative tax implications. The IRS is on the verge of issuing new final regulations that may impact certain beneficiaries, so it’s crucial to review the most recent rules with your tax advisor before making any decisions. Keep in mind that withdrawals from a traditional IRA may increase your taxable income, which will be taxed at your ordinary income rate.