The SECURE Act and Inherited IRAs
Any time you inherit assets, it's an appreciated windfall. However, there are times when an unexpected windfall comes with strings attached. This is the case when you Inherited IRAs. The rules governing the inheritance of an IRA depend on whether you have a traditional or a Roth account and whether or not you're the spouse of the deceased IRA owner.
The SECURE Act (short for “Setting Every Community Up for Retirement Enhancement Act”) went into effect on January 1, 2020. This legislation contains many rules that have a profound impact on many aspects of retirement savings. One area in which the SECURE Act had perhaps the most significant impact is inherited IRAs.
Here are some important details you need to know about inheriting a Roth IRA.
What Is an Inherited IRA?
An inherited IRA is an IRA account that is opened when you inherit an IRA or the proceeds of a 401(k) or similar retirement account from the original account holder upon their death. The beneficiary typically opens an inherited IRA account at the broker or custodian of their choice.
The rules for inherited IRAs have always been complex. But the SECURE Act made them even more complex.
RMDs and Inherited IRAs
Inherited IRAs can be subject to required minimum distributions (RMDs). But this depends on the timing and who the beneficiary is. Nothing changes for those who were taking their RMDs from an inherited IRA account prior to January 1, 2020. They continue to take their RMDs as before.
But for some beneficiaries who inherit an IRA on or after January 1, 2020, the rules have changed as discussed below.
What's Changed With the SECURE Act?
The biggest change due to the SECURE Act is the elimination of stretch IRAs for many non-spousal beneficiaries. Beginning with IRAs inherited on or after January 1, 2020, non-spousal beneficiaries must take a distribution of the full amount of the inherited IRA within a 10-year period. This includes both traditional IRA and Roth IRA accounts.
Exceptions to this rule are made for certain non-spousal beneficiaries:
- A minor child of the original account owner (but not a grandchild). In this case, once the minor child reaches the age of majority they must take a full distribution from the account within 10 years.
- A beneficiary who is less than 10 years younger than the original account owner.
- A beneficiary who is deemed to be disabled or chronically ill under the IRS rules.
Inheriting an IRA From a Spouse
The rules have not changed for someone inheriting an IRA from their spouse who was the original account owner. The beneficiary can treat the inherited IRA as their own. This includes both traditional and Roth accounts, though RMDs are not required of Roth IRAs.
- The spouse can treat the IRA as their own by designating themselves as the account owner. In this case, RMDs occur based on their age. They can wait until age 72 to begin their own RMDs. This applies even if their spouse was already taking their RMDs. (As mentioned, no RMDs are required from Roth IRAs.)
- The surviving spouse can open a separate inherited IRA account. In this case, the surviving spouse's RMDs from the account are determined by the age of their deceased spouse. For a surviving spouse who is older than the account holder, this can provide some extra time until RMDs must start. If the original account holder had not commenced RMDs at the time of their death, the RMDs from the inherited IRA begin at the age they would have been required to begin their RMDs.
- They can take a distribution of all or part of the account. Any tax still applies, but there are no penalties if they are under age 59½.
Inheriting an IRA From a Non-spouse
IRAs inherited on or after January 1, 2020, will be subject to the new rules for all non-spousal beneficiaries excluding the exceptions mentioned above. These non-spousal beneficiaries must take a full distribution from the account within 10 years. In the case of a traditional IRA, these distributions will be taxed. If the beneficiary is under age 59½ the normal 10% penalty will not apply.
The same 10-year window applies to inherited Roth IRA accounts as well. And as long as the original account holder had met the five-year rule for the Roth IRA prior to their death, distributions from an inherited Roth IRA can be made tax-free.
The non-spousal beneficiaries listed above who are exempt from the 10-year distribution clock can continue to take RMDs from their inherited IRA as per the rules in place prior to January 1, 2020.
- If the original account holder had reached age 70½ and was taking their RMDs, the beneficiary needs to begin taking the RMDs by December 31 following the year of the account owner's death. Or they could use the five-year rule which requires them to withdraw all funds from the account within five years. Taxes still apply but there would be no penalties on these withdrawals.
- If the original account holder died before age 70½, the beneficiary has the choice to take RMDs based upon their own life expectancy or that of the deceased. If they are younger than the original account holder, the stretch IRA can come into play. RMDs must commence by December 31 of the year following the year of the account holder's death.
Inherited Roth IRAs and the SECURE Act
The elimination of the stretch IRA for most inherited IRA beneficiaries pushed Roth IRAs into the spotlight as an estate planning tool.
Roth IRA distributions in which the original account holder has met the five-year rule are tax-free to the beneficiaries. So it may behoove the original account holder to convert some or all of their traditional IRA assets to a Roth IRA. They also must of course live for at least five years in order for the converted assets to be passed on to their non-spouse beneficiaries tax-free.
The downside is that they pay tax on the converted amount during their lifetime. But the beneficiaries benefit by not having a potentially large portion of the inherited IRA eroded by income taxes.
There are a lot of planning considerations here. These include the age and health of the original account holder as well as their income and tax situation.
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Inherited IRAs have been a great way to pass wealth on to the next generation or to a spouse. The SECURE Act upended much of this prior planning in the case of most non-spousal beneficiaries. IRA account holders should review their plans for beneficiaries in light of these new rules to see if any changes are in order.