We’ve had a lot of questions lately about inheritances, specifically around IRAs and other retirement accounts. The rules changed in 2020. If the person you are inheriting an account from passed away in 2020 or later, the account falls under the SECURE Act rules.
Before we discuss the new rules, a couple of quick definitions. A Required Minimum Distribution, or RMD, is that amount you must take out of the account each year, or face taxes on the RMD amount plus a 25% penalty. A Qualified Charitable Distribution, or QCD, is a payment made from a retirement account directly to a nonprofit organization, something you can do starting at 70 ½. It satisfies your RMD and isn’t included in your taxable income. A traditional account was funded with pre-tax money, and distributions are taxed as ordinary income. A Roth account was funded with after-tax money, and no taxes are due for normal distributions.
With those definitions in mind: If the beneficiary is the deceased’s spouse, the widow or widower can roll the account into their own IRA. It is then treated the same as if it was always their account, and follows the same rules for distributions, including RMDs, and QCDs. The one time you might not want to do this is if there was a significant age gap between the spouses. For example, when I’m 85, a handsome 25-year-old falls madly in love with me, and we marry. If I pass a few months later, he may not want to wait until 59 ½ to tap into all of my retirement funds. He can choose to treat the inheritance as if we weren’t married, and roll it into an inherited IRA.
When someone other than the spouse inherits a retirement account, all of the money in the account must be distributed out within ten years. While the SECURE Act did not specify that RMDs needed to be taken from the inherited IRA, the IRS has decided that RMDs must be taken. That said, they have also waived all penalties for not taking them through 2024.
If you’ve inherited a retirement account, you have a few options. You can take just the RMD each year, investing the rest of the money as you see fit, and letting it grow until the end of the ten years. At that point, you remove all the money from the account and pay taxes on it. The downside is that, depending on the size of the account, this could mean much of the account is taxed at a higher rate.
You can also choose to spread the tax bill evenly over the ten years, removing 1/10 of the account each year. If you don’t need the funds, you can then invest the after-tax amount. If you’re close to retirement, you may also want to take just the RMD each year until you stop working, then use the remaining portion to fund the first few years of retirement.
Roth IRAs are a bit different. You don’t have to take any RMDs from a Roth account. Depending on your situation, you may want to invest the account aggressively, and let it grow for ten years. Then, take the full account value out completely tax free, including any growth over the last ten years.
There are tweaks in the rules for minor children, and individuals with disabilities. And if you are leaving money to a nonprofit, donating an IRA is tax efficient, as no tax is paid by the nonprofit on the funds.
Finally, if you don’t have a beneficiary on your account, it is paid to your estate and must be distributed within five years. This is the worst-case scenario. Your heirs lose five years of tax-sheltered growth. In the case of a Roth account, they lose five years of tax-free growth.
Your action item is to check the beneficiaries on all of your retirement accounts. While you’re at it, check your pensions and life insurance, too.
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