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Inherited Individual Retirement Accounts (IRAs) are opened when someone inherits an IRA or employer sponsored account after the original account holder’s death. Though you can inherit an account from anyone, be it a spouse or not, the rules for these accounts are different depending on your relationship with the decease. Regulations on these accounts have increased and become more complicated after the Setting Every Community Up For Retirement Enhancement (SECURE) Act of 2019 was enacted. [1]

Key aspects of Rollover IRAs:

The assets from a deceased person’s IRA, whether a Traditional, Rollover, SEP, and/or SIMPLE IRAs, will be transferred to the beneficiary to distribute the funds. 1

  • The beneficiary’s distribution options from the inherited account depend on whether they are Eligible Designated Beneficiary, Designated Beneficiary, or Non-Designated Beneficiary. These designations are based on:
    1. The date of the original owner’s death.
    2. Your age and relationship to the original owner.
    3. Directives within the original account agreement.[2],[3]
  • Eligible Designated Beneficiaries would be listed as the beneficiary on the original account and are also the decease’s legal spouse, minor child of the deceased, a chronically ill or disabled beneficiary, or an inheritor who is less than ten years younger than the original owner of the account. 2,3
  • Designated Beneficiary would be listed as the beneficiary on the original account but have none of the other relationships, age, or health concerns listed above. 2,3
  • Eligible Designated Beneficiaries and Designated Beneficiary have three distribution options:
    1. Open an Inherited IRA and take distributions over time. 2,3,[4]
      • The Ten-Year Rule– The entire IRA balance must be withdrawn by December 31st of the tenth year after the original owner’s death.
      • No additional contributions can be made to this account after the transfer of funds from the original account(s).
      • Required Minimum Distributions (RMDs) amounts for the Inherited IRA will be based on your age.[5]
      • If the original account owner was under the RMD age at death, the distributions need to start from the account by December 31st of the year following the year they passed. 5
      • If the original account owner was over the RMD age at the time of death, the distributions need to start from the account by December 31st of the year following the year they passed. Unless the deceased was meant to take an RDM for the year and hadn’t before their death, you will need to take the amount they were supposed to or incur the 50% penalty they would have had if they lived the full year without taking the RDM. 5
      • If the inheritor is a minor child, the RMDs required are delayed until the child reaches 18 years old. The Ten-Year Rule starts at the inheritor’s 18th year, leaving them ten years to withdraw the money.[6]
    2. Take a lump-sum distribution. 2,3,4
      • You would pay the taxes on the amount distributed from the fund. However, this distribution does not have the additional withdrawal penalty for those under 59½ that IRAs typically have.
      • This lump-sum distribution may move the inheritor into a higher tax bracket incurring additional taxes for that year.
      • The tax-deferred earning potential is lost with a slower distribution strategy.
    3. Disclaim the account. 2,3,[7]
      • You would refuse the inheritance.
      • You would not need to worry about the Ten-year rule or any
      • People disclaim inherited IRAs for many reasons: they want a contingent beneficiary to have the money, they don’t want the added tax burden, they are shielding the money from bankruptcy, the money could affect their access to financial aid, etc.
  • Eligible Designated Beneficiaries that are spouses and sole beneficiary listed on the account have more options still with what they do with the account. They can: 2,3,4,[8],[9],[10]
          • Treat the account as their own.
          • They can transfer or rollover the funds to their own account:
            • IRA
            • Qualified employer plan,
            • Qualified employee annuity plan (section 403(a) plan),
            • Tax-sheltered annuity plan (section 403(b) plan),
            • Deferred compensation plan of a state or local government (section 457 plan)
              • These convert funds would now have the rules of the beneficiary spouse’s account, and waiver of the withdrawal penalty for those under 59½ would revert to the rules of the IRA that the money is in now.
              • These funds can grow tax-deferred along with the rest of the spouse’s IRA.
              • This transfer must be done within 60 days.
              • This option might not be the right one if there is a financial need that the surviving spouse has in the present because the money can’t be touched without penalty until 59 ½, with some exceptions. An example of why someone might not choose this option would be a surviving spouse needing financial help with the care of minor children.
          • They can treat themselves as a beneficiary and follow the rules that the other Eligible Designated Beneficiaries follow.
  • Non-Designated Beneficiaries are people listed in a will or a trust. Still, they are not listed as beneficiaries on the original account-these heirs will have to consult the executor of the will or the trustee of the trust to determine how to distribute funds from these accounts. 2
      • These inheritors have slightly different rules than Eligible Designated Beneficiaries or Designated Beneficiary. They still can open an Inherited IRA, but if the deceased were under their RMD age, those funds would need to be distributed in 5 years, not 10. If the deceased is past the RMD age, the distributions will continue based on the deceased’s RMD schedule.
      • Non-Designated Beneficiaries also have the options of Lump-sum distribution or disclaiming the account.
  • If the original owner’s death was on or after 01/01/2020, the beneficiary rules changed in the SECURE Act will affect the inheritor distribution options as an Eligible Designated Beneficiary or Designated Beneficiary. Any death before this date would be able to follow the stretch rules that were allowed before. 6
  • Though Inherited IRAs have vastly different distribution rules than other investment accounts, they are still investment accounts. And with all investment accounts, you expose some or all your invested money to loss for the chance to earn a higher profit. Investment gains hinge on an ongoing and long-term investment strategy that uses your risk tolerance and diversification to mitigate some risks. Even with these in place, you are exposing your money to loss.[11]
  • Investment options within these accounts are almost anything- individual stocks, mutual funds, ETFs, annuities, UITs, etc. There are investment vehicles that are not allowed in IRAs, including Life Insurance, types of Derivatives Positions, antiques/collectibles, personal real estate, and most coins. [12]
  • Fees vary from institution to institution. It is crucial to understand how much you are paying in fees.
  • Investment control is either by your chosen institution or advisor or can be self-directed. With this type of account, you must be aware of your risk tolerance and diversification strategy. These are especially important if you are self-directed, and you need to make changes to your investments as you make changes to your life and risk tolerance.[13]

If you want to explore additional retirement investment accounts that could work for your goals, Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here.

Sources:

[1] https://www.investopedia.com/terms/i/inherited_ira.asp

[2] https://www.schwab.com/resource/lets-talk-about-the-retirement-account-you-inherited

[3] https://www.investopedia.com/articles/personal-finance/102815/rules-rmds-ira-beneficiaries.asp

[4] https://eresourcecenter.ascensus.com/idcpro/groups/public/@resourcecenter/documents/webcontent/T014412.pdf

[5] https://www.investopedia.com/articles/personal-finance/102815/rules-rmds-ira-beneficiaries.asp

[6] https://www.investopedia.com/ask/answers/09/stretch-ira.asp

[7] https://www.investopedia.com/articles/retirement/03/041603.asp#reasons-for-disclaiming-inherited-assets

[8] https://www.marketwatch.com/story/who-is-exempt-from-the-10-year-rule-when-inheriting-an-ira-11620952971

[9] https://www.irs.gov/publications/p590b#en_US_2020_publink1000230539

[10] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary

[11] https://www.investor.gov/sites/investorgov/files/2019-02/Saving-and-Investing.pdf

[12] https://www.investopedia.com/articles/retirement/11/impermissable-retirement-investments.asp

[13] https://www.nerdwallet.com/article/investing/ira/what-is-a-traditional-ira

 

Advisory services offered through Capital Asset Advisory Services, LLC, a Registered Investment Advisor. This material has been prepared for informational purposes.