If you are the son, daughter, brother, sister, or even a close friend of an IRA owner who has named you as his or her beneficiary, it's critical that you—and the owner of the IRA—understand the rules that govern IRA inheritances.
“While the rationale behind the creation of IRAs was quite simple, the rules for inheriting and distributing assets upon the death of an IRA owner have become anything but,” says Ken Hevert, vice president of retirement products at Fidelity. “If IRA owners and their beneficiaries are not careful, they could end up paying higher taxes or penalties and forfeiting the opportunity for future tax-advantaged growth.”
Here is what you need to know about inheriting IRA assets as a nonspouse beneficiary.
The rules for inheriting IRA assets depend on your relationship to the original IRA owner and the type of IRA owned. There are also two important ages to keep in mind as you mull your options: 70½ and 59½.
The IRS requires IRA owners to start taking minimum required distributions (MRDs) no later than April 1 following the year in which they turn 70½.1 These rules also apply to whoever inherits an IRA. In addition, distributions taken prior to age 59½ (either by the IRA owner or the inheritor) could be subject to a 10% early withdrawal penalty, depending on the type of IRA.
Your ultimate course of action will be determined by your age, the age of the IRA owner, your income needs, and the type of IRA you inherit. As a nonspouse beneficiary, you do not have the option of rolling the assets into your own IRA. If you inherit IRA assets from someone other than your spouse, you generally have two options from which to choose:
1. Transfer the assets to an inherited IRA beneficiary distribution account.
When you transfer assets from a traditional IRA into an IRA beneficiary distribution account (inherited IRA), the rules for MRDs still apply. This means you must withdraw a certain amount of money from your inherited IRA each year, based on your age and life expectancy. In the case of a nonspouse inheritor, though, MRDs will need to begin before the inheritor reaches age 70½. However, if the original IRA was a Roth IRA and the assets were in the account for five years or more, prior to the death of the original owner, distributions may be tax free. Consult a tax adviser if you feel you’ve inherited a Roth IRA that wasn’t opened for five years before the original owner passed away.
Generally, you have until December 31 of the year following the original IRA owner’s death to take your first MRD. Each year thereafter you will be required to take an MRD until the account is depleted or you pass away, at which time the assets will pass to your beneficiaries. The beneficiary's MRDs will be calculated using your age in the year following your death and based on the Single Life Expectancy table.
If the original IRA owner died before reaching age 70½ (before MRDs would be required of the original owner), you also have the option of distributing your inherited IRA under the five-year rule. This allows you to take distributions however you like without penalty, so long as all assets are completely distributed from your inherited IRA by December 31 of the fifth year following the IRA owner’s death. Discuss with your tax adviser the potential tax implications of this accelerated withdrawal schedule.
If the original IRA owner died after reaching age 70½, then you must continue to take annual MRDs from your inherited IRA. You may elect to calculate those MRDs by using your own age (see the discussion above) or by using the deceased IRA owner’s age in his or her year of death. This option may be advantageous if the deceased IRA owner was younger than you.
If you are listed as a nonspouse beneficiary along with one or more other beneficiaries, it’s important to separate your shares of the decedent’s IRA in your name and then complete your first MRD by December 31 of the year following the original IRA owner’s death. If you don’t meet this deadline, your MRD calculation will be based on the oldest beneficiary’s life expectancy. If that person is older than you are, you will need to take larger MRDs, which will deplete your tax-advantaged assets more quickly.
When you establish an inherited IRA, be sure your IRA custodian registers the account properly. The account registration should include the name of the person who died, an indication that the account is an IRA beneficiary distribution account, and the inheritor’s name. Note that different IRA custodians may have varying interpretations of the IRS's rules regarding account registrations.
What to do with the money?
Once the assets have been transferred to an inherited IRA in your name, you have two options: leave the assets in the account (with the exception of annual MRDs) or or take cash distributions, as discussed above.
If you don’t have an immediate need for the money, leaving the assets in the inherited IRA may be the wisest move over the long term. That is because the longer you keep the money there, the longer you will enjoy tax-deferred growth, or, in the case of an inherited Roth IRA, tax-free growth. On the other hand, when you take money out of an inherited IRA, it will be taxed as ordinary income. The more you withdraw from an inherited IRA now, the less you will have to build on for the future.
2. Disclaim (decline to inherit) all or part of the assets.
If you decline to accept all or part of the IRA assets you are entitled to, they will pass to the other eligible beneficiaries. If no other beneficiaries exist, the assets will pass to the original IRA owner’s spouse and then to the estate. A decision to disclaim IRA assets must be made within nine months of the original IRA owner’s death and before you take possession of the assets. This is an irrevocable decision. Therefore, as with any tax-related matter, it’s critical that you consult a tax adviser or attorney before disclaiming IRA assets.
Other key points to remember
Pay close attention to your first withdrawal
A separate MRD will be required if the original IRA owner was 70½ or older at the time of his or her death and he or she didn't take the first MRD before passing away. If that's the case, this money must be distributed to you after transferring the rest of the assets to an inherited IRA in your name. Also, the money must be distributed by December 31 of the year in which the IRA owner died. The amount of that MRD will be based on the IRA owner's age, but the assets will be distributed to you under your Social Security number. You should consult a tax adviser to ensure that this "year of death" MRD is properly reported to the IRS. Contact your financial provider to inquire about how it handles "year of death" distributions, as firms may differ in the way they provide this service.
Determine whether you are listed as someone’s beneficiary. While it may be a sensitive topic to broach with elderly parents, siblings, or others, knowing in advance that you are listed as a beneficiary can help you avoid some potentially costly mistakes. As life events such as marriage, divorce, and deaths occur, it’s in your best interest (and the IRA owner’s) to confirm that beneficiary designations are up to date. Remember that IRA beneficiary designations supersede a will.
Request a trustee-to-trustee transfer. Make sure that any assets transfer directly from one account to another or from one IRA custodian to another. There is no option for a 60-day rollover when inheriting IRA assets. If you receive a check, the money will be taxed as ordinary income, and is ineligible to be deposited into an inherited IRA you may own at another firm, or back into the inherited IRA that it was withdrawn from to begin with.
Commingling of IRAs is not permitted. If you inherit different types of IRAs (Roth, traditional, SEP, etc.) from other IRA owners, you cannot combine them into a single inherited IRA. As for commingling IRAs of the same account type, the answer differs based on whether they were inherited from the same original owner or different owners. Consult a consult a tax adviser regarding this situation. Distribution rules will vary for entities such as trusts, estates, or charities.
Also, note that the Supreme Court recently ruled that an inherited IRA held by a nonspouse beneficiary is not exempt from attachment by creditors under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. While some states have laws that still may protect inherited IRAs, for a nonspouse beneficiary living in a state without such laws, the inherited IRA is effectively now treated as any other account owned by the beneficiary for bankruptcy purposes, and may not be protected under bankruptcy from claims by creditors. It is not clear whether and how this decision affects an inherited IRA held by a spousal beneficiary. Beneficiaries should be reminded to speak to their lawyer or tax adviser before taking any distribution from a retirement account or if they have specific questions regarding protection from creditors.
Guidance provided by Fidelity is educational in nature, is not individualized, and is not intended to serve as the primary or sole basis for your investment or tax-planning decisions.