If you are the son, daughter, brother, sister, or even a close friend of an IRA owner who has named you as their beneficiary, it's critical that you—and the owner of the IRA—understand the rules that govern IRA inheritances.
Whatever your situation, a discussion in advance with your attorney or tax adviser may help you avoid any unintended consequences.
"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, senior 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 inherited.
The IRS generally requires nonspouse inherited IRA owners to start taking required minimum distributions (RMDs) beginning December 31 after the year of death of the original account owner, and each year thereafter. Also, distributions from inherited IRAs taken before age 59½ are not subject to a 10% early withdrawal penalty in most cases.
Your ultimate course of action will be determined by your age, the age of the original IRA owner, your income needs, any creditor protection concerns, and the type of IRA you inherit. Be sure to consider all your available options and the applicable fees and features of each before taking any action.
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 2 options from which to choose:
1. Transfer the assets to an inherited IRA and take RMDs
When you transfer assets from a traditional IRA into an inherited IRA, sometimes also referred to as a beneficiary distribution account, there are RMD rules to follow, set by the IRS. This means you need to 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, RMDs are generally required to begin in the year after the year of death, and these rules require that you withdraw the full RMD amount for each year required. The RMD for your inherited IRA will be calculated using your age in the year following the year of death and based on the IRS Single Life Expectancy table. Other options exist for how the RMD is calculated, or if using the 5-year rule, see below.
Note: The beneficiary must be an individual (not a company or a trust), be named by the original owner, and have followed the IRS rules around separating accounts. Different rules apply if you don’t meet these 3 criteria. For subsequent years, the life expectancy factor is determined by subtracting one from each year since the year of death from the initial life expectancy factor.
If the original IRA owner died after reaching age 70½, then you may elect to calculate those RMDs by using your own age (see the discussion above) or by using the original IRA owner's age in their year of death. This option may be advantageous if the original IRA owner was younger than you. For subsequent years, the life expectancy factor is derived by subtracting one for each year.
If the original IRA owner died before reaching age 70½ (before RMDs would be required of the original owner), you also have the option of distributing your inherited IRA under the 5-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 5th year following the IRA owner’s death. Discuss with your tax adviser the potential tax implications of this accelerated withdrawal schedule.
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 RMD by December 31 of the year following the original IRA owner's death. If you don't meet this deadline, your RMD 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 RMDs, 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 you inherited from, 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.
If you inherit a Roth IRA that was funded for 5 years or more prior to the death of the original owner, distributions can be taken tax free. Consult a tax adviser if you've inherited a Roth IRA that wasn't funded for 5 years before the original owner passed away.
What to do with the money? Once the assets have been transferred to an inherited IRA in your name, you have 2 options: Leave the assets in the account (with the exception of annual RMDs) or take additional 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 (again, subject to the RMD rules). This is because the longer you keep the money there, the longer you will enjoy potential tax-deferred growth, or, in the case of an inherited Roth IRA, potential tax-free growth. On the other hand, when you take money out of an inherited IRA, it will generally 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 in accordance with the IRA provider's contractual defaults. For example, with a Fidelity IRA, the assets will pass to the original IRA owner's surviving spouse and, if none, to the owner's estate. A decision to disclaim IRA assets must be made within 9 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 or estate planning matter, it's critical that you consult a tax adviser or attorney before disclaiming IRA assets.
Other key points to remember
Determine whether you are listed as someone's beneficiary. While it may be a sensitive topic to broach with loved ones, knowing in advance that you are listed as a beneficiary can be helpful. As life events such as marriage, divorce, and death 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 a nonspouse beneficiary is inheriting IRA assets. If you receive a check, the money will generally 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.
Distributions from an inherited IRA can be invested in other accounts. Consider all your options when taking RMDs and other distributions from an inherited IRA. Generally, your distribution is included in your gross income and will be subject to ordinary state and federal income taxes. Once funds are distributed from an inherited account, the money is your own.
Commingling of inherited IRAs. If you inherit IRAs from different owners, you cannot combine them into a single inherited IRA. As for commingling IRAs of the same account type, the answer differs when they were inherited from the same original owner, which is allowed. Consult a tax adviser regarding your situation. Distribution rules will vary for entities such as trusts, estates, and charities.
Nonspouse beneficiaries do not have bankruptcy protection with inherited IRAs. Also, note that the Supreme Court 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 with their lawyer or tax adviser before taking any distribution from a retirement account or if they have specific questions regarding protection from creditors.
Next steps to consider
Take advantage of potential tax-deferred or tax-free growth.
Find out if you're contributing enough to your retirement savings.
If you own a traditional IRA, learn about withdrawals you're required to take.