An inherited individual retirement account is created with the funds in an IRA or employer-sponsored retirement plan after the original owner dies. You are not able to make more contributions to the account after inheriting it. In addition, you will need to take distributions according to specific rules, which vary based on your age and relationship to the deceased.
To learn more about the inherited IRA 10-year rule, start with the following:
— Understanding the inherited IRA 10-year rule.
— How does the 10-year rule work?
— Factors to consider in the 10-year rule.
— Strategies to optimize the inherited IRA 10-year rule.
[Read: How to Manage an Inherited IRA.]
Understanding the Inherited IRA 10-Year Rule
The inherited IRA 10-year rule refers to how assets in an IRA are handled when an IRA owner dies and the account is passed on to the named beneficiary. For some beneficiaries, including non-spouses, all the funds must be withdrawn within 10 years of the previous owner’s passing. Spouses who inherit an IRA have other options to consider. There are exceptions for beneficiaries who meet certain criteria. The 10-year rule applies to those who have inherited an IRA on or after Jan. 1, 2020.
The inherited IRA 10-year rule changed the way this type of account is handled when it passes from one account holder to another. It came into effect by way of the SECURE Act, which passed in December 2019 and became law as of Jan. 1, 2020. “The biggest change was how long a non-spouse beneficiary had to withdraw the assets from the retirement account,” said David J. Bross, senior estate planner at Truepoint Wealth Counsel in the Cincinnati metro area, in an email.
Prior to the SECURE Act, a non-spouse beneficiary could take a required minimum distribution each year from the account. The RMD was calculated using their life expectancy. The SECURE Act changed the life expectancy-based distributions by requiring that the funds from the account be withdrawn within a 10-year window. In cases “with all distributions from a retirement account qualifying as ordinary income to the beneficiary, this means that beneficiaries will pay income tax on the full value of the retirement account within that 10-year period,” Bross said. “This eliminates the ability of the beneficiary to keep the retirement account funded for their life to secure the long-term tax-free growth.”
[See: 10 Steps to Max Out Your IRA]
How Does the 10-Year Rule Work?
If you are a beneficiary of an IRA, you’ll want to know whether the 10-year rule applies. You can start by looking at the time you receive the assets. For non-spouses who meet certain criteria and have inherited an IRA on or after Jan. 1, 2020, the funds will need to be withdrawn within 10 years.
There are a number of exceptions, however. The 10-year rule won’t apply if you fall into the following categories:
— The IRA owner’s surviving spouse.
— The IRA owner’s minor child.
— An individual who is not more than 10 years younger than the IRA owner.
— A disabled or chronically ill person, as determined by the IRS.
However, once a minor child reaches the age of majority, they become subject to the 10-year rule. It is also possible to withdraw funds at a faster pace when you inherit an IRA. “All beneficiaries have the option to use the lump sum method,” said Aviva Pinto, a managing director at Wealthspire Advisors in the New York City metro area, in an email.
Factors to Consider in the 10-Year Rule
Spouses will have a number of decisions to make when inheriting an IRA. “Treating the IRA as your own is generally advised for most spouses,” Pinto said. Alternatively, a spouse can choose to open and transfer the assets into an inherited IRA. The funds can then be withdrawn during the 10-year timeframe.
For spouses, in cases in which the deceased was taking RMDs from a traditional IRA at the time of their death, you’ll need to take the required minimum distribution during the year they die if they have not done so already. Otherwise, you can wait until you reach the age that you need to begin taking required minimum distributions to withdraw from the account.
However, if you are a spouse under age 59 1/2 and need funds from the account, you might opt to open an inherited IRA and start taking distributions. If you take distributions from your own account prior to age 59 1/2, the funds will be subject to a 10% penalty.
The timing of the account owner’s passing plays a role when determining the next steps. If the IRA was passed to you in 2020 or later and you don’t fit any of the exceptions to the rule, you’ll need to take the funds within 10 years of inheriting the IRA. For deaths on or before Dec. 31, 2019, the old rules for inherited IRAs remain in place. Non-spouse beneficiaries are allowed to take RMDs based on their life expectancy.
[Read: IRA Rules: Contributions, Deductions, Withdrawals.]
Strategies to Optimize the Inherited IRA 10-Year Rule
If you inherit a traditional IRA with contributions that have been made with pretax dollars, withdrawals are subject to taxes. Roth IRAs are funded with after-tax dollars, and withdrawals are typically not subject to tax.
With inherited IRAs, you won’t face some of the same penalties that apply to other types of IRAs. For example, there is often a 10% penalty if you take a distribution from a traditional IRA before age 59 1/2, but you can withdraw money from a traditional inherited IRA prior to this age without facing a penalty.
“One creative strategy around the 10-year rule, for those who are charitably inclined, is naming a charitable remainder trust as a beneficiary to your IRA,” said Jonathan Shenkman, president and chief investment officer of ParkBridge Wealth Management in the New York City area, in an email. A CRT is an irrevocable trust that generates an income stream to the beneficiary with the remainder of the assets after the term of the trust. You might choose a charity that aligns with your interests as your beneficiary. “The trust term can be longer than the 10-year inherited IRA limitations and therefore allows a beneficiary to continue to stretch the tax benefits for longer,” Shenkman said.
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What Is the Inherited IRA 10-Year Rule? originally appeared on usnews.com
Update 12/18/23: This story was previously published at an earlier date and has been updated with new information.
