Inherited IRA rules are actually not well-known to most people with inherited IRAs. In fact, many people with inherited IRAs may even be unaware of the tax benefits available to them. However, in order for a surviving spouse to take full advantage of an inherited IRA, there are certain rules to consider. This includes filling out of beneficiary forms and designating primary and alternate beneficiaries. To find out more about how to set up an inherited IRA and its guidelines, read on below.
Inherited IRA Rules to Watch Out for Inside Your IRA
1. IRA Beneficiary Rules
Before doing anything else, you have to understand how to set up an inherited IRA account. For example, IRA heirs need to take note that withdrawals are only possible from one IRA custodian to another. Additionally, in cases where the heir to the IRA inheritance is a non-spouse, you have to re-title the designated beneficiary. This includes re-titling the name of the original owner, stating it has been inherited. For inherited IRAs with two or more, the inherited IRA assets need to be split separately. This will also allow longer stretch-outs for future heirs, allowing extended IRA tax-deferred growth.
2. The Rule for the Beneficiary Forms
The beneficiary forms filed under the IRA’s custodian dictates who will inherit the IRA distributions and if it can be stretched out. Keep in mind that heirs can have greater flexibility if they are under both the primary and the alternate beneficiaries. It is upon the primary beneficiary’s discretion whether to disclaim the account by turning it down or pass it on to the next younger alternate.
However, for beneficiaries including an estate, there is no continuation for tax deferrals. In Roth IRA accounts, fund withdrawals can only occur after five years. The same rule applies for traditional IRAs unless the previous owner is already 70 ½. Then they can immediately start withdrawing funds. In the absence of beneficiary forms, the default policy of the IRA’s custodian will dictate the beneficiaries and communicate this information to the heirs.
3. Employer-Sponsored Retirement Plans
The spouse receives the retirement account as mandated by federal law unless they waived their rights through a signed form. However, keep in mind there are employer plans which transfer funds directly to the children in cases of a deceased spouse and in the absence of a filed beneficiary form. The beneficiaries can then request for a transfer of funds as an inherited IRA divided separately.
4. More Options for Spouses
There are more options available for the heirs who are spouses. For example, the spouses can roll over the assets to their own IRA or self-directed IRA. They can also delay distributions until they turn 70 ½ within a traditional IRA. However, the same rule applies for penalties on early withdrawals made before the age of 59 ½ from their own IRAs.
5. Distribution Considerations
Beneficiaries of late IRA owners who are 70 ½ or older have to withdraw the mandatory distribution upon the year of death of the late owner. Then, the beneficiary may withdraw distributions during their lifetime or within 5 years after the death of the previous account holder (Five-Year Rule). There are taxes paid for every withdrawn distribution in inherited traditional IRAs. Inherited traditional IRAs also include rollover, SIMPLE IRAs, and SEP IRAs. There are no taxes for distributions in an inherited Roth IRA.
6. Disclaiming an Inheritance
Disclaiming an inheritance is only possible if the original holder of the account designated beneficiaries in the form. A will does not cover funds from IRAs, or 401(k)s and 403(b)s. The banks or the custodian will receive the forms notifying who is the beneficiary. In cases where there is no alternate beneficiary and the primary beneficiary disclaims the inheritance, the default policy under the custodial agreement follows. From here, the custodial agreement either chooses the estate or the spouse as the beneficiary.
7. Age to Make Withdrawals
You may withdraw money even before you’re 60 years old. In fact, IRA heirs who did not inherit their IRAs from their spouses need to make withdrawals each year. This should be the minimum amount made beginning December 31 the year after the death of the IRA owner. Both traditional and Roth IRA holders can make these withdrawals. Calculations for the distributions include the December 31 balance from the previous year divided by the life expectancy of the inheritor. You may refer to the IRS’ Single Life Expectancy table.
The inherited IRA rules apply to all beneficiaries — whether a spouse, a family member, a friend, a trust, or an estate. However, these rules do vary depending on which account type you have inherited, as well as the kind of relationship you have with the original account owner. Regardless of your relationship, not taking RMDs (Required Minimum Distributions) can result in a 50% IRS penalty on the amount of the RMD. This is why, if you want to keep as much of your inheritance as possible, it’s important you understand the rules when you inherit an IRA.
Remember, a retirement plan inheritance can turn into a very good financial opportunity to grow your assets. Conduct due diligence and maximize the benefits you can receive from an inherited IRA.
Which of the inherited IRA rules discussed above would you like to know more about? Share your thoughts in the comments below.