If someone you love passes and leaves you as the beneficiary to an Individual Retirement Account (IRA), what should you do? Like the answer to most personal finance questions, it depends.
Please consult with a financial planner, accountant or estate attorney who is familiar with IRA rules. Most of this information is pretty straight forward, however, if not done correctly you will be liable for taxes and penalties you could have avoided. Talk to a pro.
After saying that, let's explore your options if you inherit an IRA.
Did you inherit a Traditional IRA or a Roth IRA?
Figure out exactly what you inherited. If you aren't sure what the differences are check out my blog Roth vs. Traditional IRA: Which is Better for Me?
Traditional IRA's require owners to take minimum withdrawals at age 72. The reason for this is because a Traditional IRA is tax deferred meaning the owner has never paid income tax on this money. And since we know that death and taxes are a certainty in life, Aunt IRS (IRIS) is going to make sure she gets her fair share at some point.. Thus the government requires distributions starting at age 72 and thereafter.
This is important because if the owner of the IRA you inherit was older than 72 when they passed you have to make sure the required minimum distribution (RMD) was met for that year. If you don't, Aunt IRS will charge you a significant penalty.
If you inherited a Roth IRA, income tax has already been paid on that money. However, you need to find out exactly when the Roth account was opened. As long as the account was opened at least 5 years prior to death, withdrawals of the earnings are tax free. If the account was opened less than 5 years ago, it will be subject to income tax at your ordinary tax rate plus a penalty.
For the spouse of the deceased
What is your relationship to the original owner of the IRA? If you were the spouse one set of rules apply. If you were not the spouse a different set of rules apply.
A spouse can transfer the funds to a new or existing IRA in the spouse's name through what is known as a spousal transfer. A spouse can do this even if the original owner of the IRA was over the age of 72 and taking required minimum distributions from the IRA. If the spouse is younger than 72 they can delay the required minimum distribution until the time they turn 72. If they are over 72 this will just increase their required minimum distribution. A spousal transfer can be done with a Traditional IRA or a Roth IRA. However with the Roth IRA, they won't need to worry about withdrawals.
Important note, if you are under 59.5 years of age when you inherit the IRA as a spouse and withdrawal any money you will be subject to the 10% early withdraw penalty. If you are under 59.5 years of age you can avoid this penalty via a Stretch IRA. See below.
A spouse can choose a Stretch IRA. They can transfer the IRA into an inherited IRA. (This is different from a spousal transfer.) Once the Inherited IRA is set up the spouse can withdraw the money in two ways. The first option is the life expectancy method where you take annual distributions based on your own life expectancy, not the original owners. The second is the 10-year method. where you have to withdraw the funds evenly over the next 10 years.
For a beneficiary that isn't the spouse
You have more limited options. The Secure Act of 2019 eliminated the Stretch IRA for non-spousal heirs that inherited an IRA on or after January 1, 2020. The funds from the inherited IRA, whether Roth or Traditional, must be distributed within 10 years of the death of the original owner. This applies whether the original owner died before age 72 or after age 72.
There are some exceptions to this. An example would be that if the heir was a minor, disabled, or not more than a decade younger than the original IRA owner they can withdraw using the Stretch IRA method listed above. Meaning they can withdraw based on their life expectancy.
If you are required to withdraw the funds within ten years, you do not have to spread that out evenly over ten years. For example, you could let the funds grow and withdraw the entire amount in year 10. However, keep in mind that could put you in a higher tax bracket depending on whether you are dealing with a Roth IRA or a Traditional IRA. You can also take it all now in one lump sum, but keep in mind that can also move you into a higher tax bracket.
If you inherit a Roth IRA you won't have to pay taxes on the distributions as long as the account was opened 5 years prior to the original account owner's death.
Confused yet? That's why we're here. Like I mentioned earlier, please talk to a pro before you make these decisions. It will save you time and money and give you some peace of mind.
You need a plan
At 80/20 Financial Services, we are retirement planners and we specialize in working with electric cooperative employees. We can help you answer questions like:
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Contact us to set up a consultation. The consultation is free and without obligation.
Thanks for reading!
80/20 Financial Services is an Independent Registered Investment Advisory Firm. We help electric cooperative employees retire.
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