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 differ depending on your relationship with the deceased. In addition, regulations on these accounts have become more complicated after the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 and the SECURE 2.0 Act of 2022 were enacted. [1],[2]
How are these accounts distributed?
The assets from a deceased person’s IRA, whether a Traditional, Rollover, SEP, and/or SIMPLE IRA, 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 the following: [2],[3]
Starting January 1, 2025, the Internal Revenue Service (IRS) will implement significant changes to the rules governing Inherited Individual Retirement Accounts (IRAs). These modifications primarily affect non-spouse beneficiaries and are designed to expedite the distribution of inherited retirement assets. 17,18
Key Changes Effective in 2025:
- Mandatory Annual Required Minimum Distributions (RMDs):
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- Non-spouse beneficiaries who inherit an IRA from an account holder who had already begun taking RMDs must start taking annual RMDs beginning in 2025. This requirement ensures that funds are distributed consistently over the 10-year period.Regardless of whether the original account owner had started RMDs, non-spouse beneficiaries are required to fully deplete the inherited IRA within 10 years following the account owner’s death. This rule applies to both traditional and Roth IRAs.
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- 10-Year Full Distribution Rule:
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- Regardless of whether the original account owner had started RMDs, non-spouse beneficiaries are required to fully deplete the inherited IRA within 10 years following the account owner’s death. This rule applies to both traditional and Roth IRAs.
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- Penalty for Missed RMDs:
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- Failure to take the required annual distributions will result in a penalty. Starting in 2025, the penalty for missing an RMD is 25% of the amount that should have been withdrawn. However, if the oversight is corrected promptly, the penalty may be reduced to 10%.
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Exceptions to the New Rules:
Certain beneficiaries are classified as Eligible Designated Beneficiaries (EDBs) and are exempt from the 10-year distribution rule. EDBs include: 18
- Surviving spouses
- Minor children of the original account owner (until they reach the age of majority)
- Disabled or chronically ill individuals
- Individuals not more than 10 years younger than the deceased account owner
These beneficiaries may continue to take distributions based on their life expectancy, allowing for a more extended payout period.
Eligible Designated Beneficiary
is someone listed as the beneficiary on the original account and is the deceased’s legal spouse, a minor child of the deceased, a chronically ill or disabled beneficiary, or an inheritor less than ten years younger than the original owner of the account. 2,3
Designated Beneficiary
is someone listed as the beneficiary on the original account but has none of the other relationships, age, or health concerns of an Eligible Designated Beneficiary.2,3
Non-Designated Beneficiary
is someone listed in a will or a trust. But 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
Eligible Designated Beneficiary
The solitary beneficiary spouse can:
Designated Beneficiary
Eligible Designated Beneficiary and Designated Beneficiary can:
Implications for Beneficiaries for 2025 Changes:
- Tax Considerations: Annual distributions from traditional IRAs are taxed as ordinary income. Beneficiaries should plan withdrawals strategically to manage their tax liabilities effectively.
- Estate Planning: The new rules may necessitate revisions to existing estate plans, especially for those intending to leave substantial IRA assets to non-spouse beneficiaries. Consulting with a financial advisor or estate planning professional is advisable to navigate these changes.
Other Key Aspects of Inherited IRAs:
- If the original owner’s death was on or after 01/01/2020, the beneficiary rules in the SECURE Act would affect the inheritor’s 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.[14]
- 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. [15]
- 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 know your risk tolerance and diversification strategy. These are especially important if you are self-directed and need to make changes to your investments as you make changes to your life and risk tolerance.[16]
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 you can contact us here. To sign up for our weekly newsletter with the latest economic news, click here.
Sources:
[1] https://www.investopedia.com/terms/i/inherited_ira.asp
2] https://www.irs.gov/pub/irs-drop/n-23-54.pdf
3] https://www.schwab.com/resource/lets-talk-about-the-retirement-account-you-inherited
4] https://www.investopedia.com/articles/personal-finance/102815/rules-rmds-ira-beneficiaries.asp
5] https://www.marketwatch.com/story/who-is-exempt-from-the-10-year-rule-when-inheriting-an-ira-11620952971
6] https://www.irs.gov/publications/p590b#en_US_2020_publink1000230539
7] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
8] https://eresourcecenter.ascensus.com/idcpro/groups/public/@resourcecenter/documents/webcontent/T014412.pdf
9] https://www.investopedia.com/articles/personal-finance/102815/rules-rmds-ira-beneficiaries.asp
10] https://www.investopedia.com/ask/answers/09/stretch-ira.asp
11] https://www.investopedia.com/articles/retirement/03/041603.asp#reasons-for-disclaiming-inherited-assets
12] https://taxschool.illinois.edu/post/navigating-the-new-regulations-for-inherited-iras/
13] https://www.forbes.com/sites/kristinmckenna/2023/07/19/beneficiaries-of-inherited-iras-get-more-rmd-relief—for-now/?sh=6d758d043266
14] https://www.investor.gov/sites/investorgov/files/2019-02/Saving-and-Investing.pdf
15] https://www.investopedia.com/articles/retirement/11/impermissable-retirement-investments.asp
16] https://www.nerdwallet.com/article/investing/ira/what-is-a-traditional-ira
17] Kiplinger.com
This material has been prepared for informational purposes. *To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances.