What exactly is an Inherited IRA?
Inheriting an IRA can be even more complicated than the already complex world of inherited Individual Retirement Accounts (IRAs). Understanding the rules and regulations about inheriting an inherited IRA is critical to avoid major tax pitfalls, according to a recent article from yahoo! finance, “What Happens When I inherit an Annuity?”
Except for spouses who roll an IRA into their own IRA, the rules that apply to an inherited IRA are not the same rules that apply to your own IRA. It becomes a separate account that you DO NOT contribute to. The withdrawal rules and penalty rules are quite different.
Until December 2019, if you inherited an IRA, you could withdraw the funds over the course of your life expectancy, based on actuarial tables. At 20, you might have 60 years to withdraw, while the funds grow tax deferred.
That all changed over the Christmas vacation in 2019 when Congress screwed many future beneficiaries with the “SECURE Act.” They “Secured” much earlier payment of taxes on your money. Exceptions were created for those with Special Needs and if born within 10 years of the decedent.
After the passage of the SECURE Act, the rules concerning inherited IRAs became quite restrictive. Working with an estate planning attorney knowledgeable about IRAs can be the difference between a healthy inheritance or an unexpected huge tax liability.
An inherited IRA is an IRA left to a beneficiary following the death of the original account owner. The beneficiary who inherits the IRA can pass it to a successor beneficiary upon death. This creates the “inheriting an inherited IRA” scenario.
If the line of succession is not set up correctly, there is the potential for inherited assets to go through probate for a judge to rule on the rightful owner.
The original beneficiary is the first person to inherit the IRA. Once they have inherited the account, they may name their successor beneficiary. There are rules for the original beneficiary and the successor beneficiary.
The SECURE Act changed the timeline for withdrawals from an inherited IRA. It eliminated the “stretch” IRA strategy, which allowed beneficiaries to take distributions over their lifetime, stretching out the tax-deferred growth of the IRA over decades. Now, most non-spouse beneficiaries must withdraw all assets from an inherited IRA within ten (10) years of the original account holder’s death. This change presents new tax implications, especially if the beneficiary is in their peak earning years.
Inheriting an inherited IRA can involve complex tax rules and pitfalls. There are timelines for taking required withdrawals and zero flexibility for mistakes.
You’ll also need to be sure the inheritance is documented correctly to avoid potential probate.
The rules differ for spouses inheriting an IRA since they share assets with their deceased spouse. The SECURE Act allows spouses to treat the IRA as their own, providing more flexibility in distributions and potential tax implications.
Understanding the concept of Year of Death Required Distributions is essential. Let’s say the original owner was over a certain age at death. In this situation, a Required Minimum Distribution (RMD) may need to be taken in the year of death, which could impact the heir’s taxes for that year.
Knowing potential tax breaks related to inherited IRAs will also help with financial management. Non-spouse beneficiaries can deduct the estate tax paid on IRA assets when calculating their income tax.
If you are inheriting an IRA, talk to an estate planning attorney before transferring the funds. If you don’t need the funds, some of our clients choose to pass the funds on to their children using a disclaimer. This is only possible before claiming the account.
These are complex issues requiring the help of an experienced estate planning attorney. Ideally, the conversation about what happens when you inherit an inherited IRA should occur while creating or revising your estate plan.
Reference: yahoo! finance (Sep. 5, 2023) “What Happens When I inherit an Annuity?”