There are several ways an inheritance may be passed from one person or entity to another, and one of these is through an individual retirement arrangement, aka IRA account.
At Rowland Miller + Partners, we provide investment management, and retirement planning is an important aspect of assisting clients with their investment objectives. We manage many IRA portfolios for clients; following is basic information on types of IRAs you may now or someday own. As always, we encourage you to consult a tax professional before taking any action. These accounts are simple conceptually and are governed by many specific rules and processes that could cost you penalties at tax time if not adhered to; an overview follows.
Determining Beneficiary Type
Under current law, there are three primary ways (these are not exhaustive) to inherit an IRA:
- Spousal beneficiary. These inherited IRAs result from a spouse’s IRA or 401(k). The delineation is important, as spouses are not subject to the same schedule of required distributions or withdrawals as other beneficiaries described below. If you inherit a spousal IRA, the primary schedule used for distributions currently specifies that you must begin them in the year you turn 72.
- All other named beneficiaries will have an Inherited IRA. Depending upon when you inherited the IRA, you may be able to extend the period over which you are required to make distributions. If inherited prior to January 1, 2020, you will utilize a schedule like that of a spouse, which incorporates life expectancy tables. If your inherited IRA comes to you after that date, you are required to fully distribute the account within 10 calendar years after the death of the individual who funded the IRA starting by December 31st of the year in which your benefactor passed away. Failure to correctly distribute the funds may cost you a 50% penalty.
- Non-designated beneficiary: If the original owner named their estate as the beneficiary, the heir(s) would inherit the IRA via the will (in contrast to being a named beneficiary). In such a case, the heir may be subject to different, stricter rules regarding distributions.
- Other: minor children (under 18 most states), disabled individuals or those less than 10 years younger than the original owner, may qualify for treatment similar to a spousal IRA. Consult a professional or the IRS code for specific treatment.
Sole or Shared Beneficiary?
It’s vital to ascertain whether you inherited an IRA on a “shared” or “sole” basis. Simply put, you may be the only designated beneficiary, or you may be one of several beneficiaries. In the latter case, each beneficiary inherits a share which may, or may not, be equal.
As with everything discussed herein, there are rules related to multiple beneficiaries. Be sure to understand them so as not to run afoul of deadlines that may lead to penalties.
The spouse of the deceased can roll over an inherited IRA into an existing IRA in their own name. Otherwise, an inherited IRA must be kept as an entirely separate account. Typically, the title includes the original owner and your name as the beneficiary. A potential example: “Susie Q. Inherited IRA, Beneficiary of Mom Q.”
Just in Case: Naming a Beneficiary of Your Inherited IRA
In the unfortunate event you pass prior to full distribution of the Inherited IRA, be aware of two basic rules:
- If the original beneficiary inherited the IRA before January 1, 2020, the successor beneficiary(s) will have 10 years to distribute the IRA starting the year following the original beneficiary’s death.
- If the original beneficiary inherited the IRA after December 31, 2019, putting the distribution schedule under the 10 year rule described earlier, no additional 10-year period is granted. The original 10-year period is locked in for all subsequent beneficiaries. Ex: If the original beneficiary had only 4 years left to distribute, that is the applicable timetable.
Calculate Distribution Amount
The good news: you are not required to empty the entire account in one year. The IRS website (IRS Publication 590) provides worksheets for calculating the distributions. You may also choose to consult your tax professional or an institution such as the custodian of the IRA. Importantly, the IRS rules make clear the beneficiary is “ultimately” responsible for the calculation.
Other (complicating) Factors
Some inherited IRAs may contain pretax and post-tax contributions. The calculations can be tricky and (again) there are required forms…suggesting a close relationship with the IRS website or getting with a professional who knows the ropes.
Rules Regarding Taxation of Distributions
If you inherit a Roth IRA, which is funded with after-tax contributions, the distributions are free of tax under current law.
If the IRA was funded with pre-tax contributions, distributions are currently taxed at the beneficiary’s individual tax rate. Put another way, these distributions are considered “earned income” and taxed in similar fashion to W-2 earnings.
As noted above, some IRAs may contain pre-and-post tax contributions which could be differently taxed. Working with a tax professional will make this determination an easier one.
Inheritances can be a wonderful occurrence. To keep them from turning into headaches, we work closely with our clients and their tax professionals to assist in smooth transitions for future investments.