Inheriting an Individual Retirement Account (IRA) from a parent presents unique challenges and responsibilities. For siblings who have recently inherited their father’s IRA, understanding the specific regulations is crucial for managing the account effectively and avoiding unexpected tax liabilities.
Understanding Inherited IRAs
Many beneficiaries mistakenly believe they can roll an inherited IRA into their own retirement accounts. However, according to the IRS guidelines, if you inherit an IRA from a parent or any individual other than a spouse, you cannot treat the account as your own. Instead, the funds must be transferred into a newly established inherited IRA, properly titled in the deceased owner’s name. For instance, it would appear as: John Smith, deceased, for the benefit of Jane Smith. In cases where the deceased named multiple beneficiaries, the IRA can be divided into separate inherited accounts. This arrangement allows each beneficiary to manage withdrawals independently, similar to a sole ownership scenario.
Opening an inherited IRA can be done through most banks or brokerage firms. It is often most convenient to establish the account with the financial institution that managed the original IRA.
Withdrawal Rules Under the SECURE Act
The SECURE Act, signed into law in December 2019, introduced significant changes to the rules governing inherited IRAs. Most non-spousal beneficiaries are required to withdraw all funds from the inherited IRA by the end of the 10th year following the account owner’s death. This rule applies if the account owner passed away in 2020 or later.
If the deceased had already begun taking required minimum distributions (RMDs), beneficiaries must continue those annual distributions while also ensuring the account is emptied within the 10-year timeframe. Conversely, if the deceased had not initiated RMDs, the beneficiaries are not required to take annual withdrawals, provided the account balance is fully withdrawn by the end of the 10-year period.
Withdrawals from a traditional IRA are considered taxable income for the year they are taken. In contrast, withdrawals from a Roth IRA are typically tax-free, assuming the account has been open for at least five years. Beneficiaries should be aware that failing to withdraw the required minimum amount can result in a penalty of 25 percent of the shortfall, although this penalty can be reduced to 10 percent if corrected within two years.
Exceptions to the 10-Year Rule
Certain beneficiaries are exempt from the 10-year withdrawal requirement. These include surviving spouses, minor children, beneficiaries who are disabled or chronically ill, and individuals who are within 10 years of age of the deceased IRA owner. For these beneficiaries, the option to stretch withdrawals over a longer period may be available.
While it may be tempting to cash out an inherited IRA in a lump sum or withdraw large amounts in a short period, doing so could lead to substantial tax implications. Withdrawals from a traditional IRA are taxed at the beneficiary’s ordinary income tax rate. Therefore, spreading out distributions over the 10-year period can help manage taxable income and reduce the likelihood of moving into a higher tax bracket.
To navigate these complex rules and make informed decisions about withdrawals, beneficiaries are encouraged to consult with a qualified financial adviser. This professional guidance can prove invaluable in maximizing the benefits of the inherited IRA while minimizing tax liabilities.
