An inherited IRA from a family member or friend can come with more than just unexpected funds; it may also come with potential major tax liability in the form of Required Minimum Distributions (RMDs). Navigating inherited IRA RMD rules can be complex, but understanding the basics now can help save you from major tax headaches later. This guide helps provide the essential information you need to comply with these regulations effectively.
What Are RMDs on Inherited IRAs?
Required Minimum Distributions, or RMDs, are mandatory annual withdrawals that the Internal Revenue Service (IRS) requires from tax-deferred retirement accounts. This ensures that the funds, which have grown without being taxed, are eventually distributed and taxed.
For inherited IRAs, the specific regulations—including withdrawal amounts and deadlines—depend significantly on your relationship to the original account owner and the date of their passing. The SECURE Act introduced stricter timelines for most non-spouse beneficiaries, making compliance even more critical.
How Does the SECURE Act Affect Inherited IRAs?
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 fundamentally changed the landscape for beneficiaries of inherited IRAs and 401(k)s. It requires most non-spouse beneficiaries to withdraw the full account balance within 10 years of the original owner’s death.
This 10-year rule does not apply to “Eligible Designated Beneficiaries,” a category that includes surviving spouses, minor children of the account owner, disabled or chronically ill individuals, and beneficiaries who are not more than 10 years younger than the decedent.
For all other beneficiaries, the SECURE Act’s impact on inherited IRAs is a condensed withdrawal timeline that can create challenging tax situations without careful planning.
Rules for Taking RMDs from an Inherited IRA
Inherited IRA required minimum distribution rules depend almost entirely on two things: your relationship to the original owner and the year they passed away. Here’s a quick rundown of the basics:
- Non-spouse beneficiaries: If the original owner of the inherited IRA died after December 31, 2019, you typically must withdraw the entire balance within 10 years. Depending on the circumstances, you may also have to take annual RMDs.
- Spouses: As a surviving spouse, you have greater flexibility. You can treat the inherited IRA as your own or roll it over into your IRA, which allows you to delay RMDs until your own required beginning date (currently age 73).
- Eligible designated beneficiaries (EDBs): This specific group—including minor children, disabled or chronically ill individuals, or those not more than 10 years younger than the original owner—may be permitted to “stretch” RMDs over their own life expectancy, offering a significant tax advantage.
Keep in mind that all beneficiaries, save for spouses, must generally empty the inherited IRA account by the end of the 10th year following the year of the original owner’s death and sometimes sooner under IRS life expectancy rules.
Steps Owners Can Take for Beneficiaries
Before the SECURE Act, beneficiaries of inherited IRAs and 401(k)s could often “stretch” RMDs over their lifetime to provide a sustained income stream. This “stretch strategy” could be a powerful tax benefit for loved ones, as it helped minimize the tax impact of inherited accounts.
Now such a benefit is only available to EDBs. However, there are ways that retirement plan owners can help ease the tax burden on their beneficiaries. Here are four strategies to consider with your financial advisor.
1. Convert the Accounts to a Roth IRA
Since you make contributions to all IRAs—save a Roth—and 401(k)s on a pre-tax basis, the federal government doesn’t tax investment earnings until they’re distributed. With a Roth IRA, the opposite is true, since funds were already taxed before going into the account. Thus, distributions are tax-free, including earnings from a Roth IRA, as long as they’re considered qualified withdrawals.
One way to minimize the taxes your beneficiaries will pay on an inherited IRA is to convert it to a Roth. Keep in mind, however, that a Roth conversion creates taxable income for you, the benefactor, compared to what you would have experienced if you had not completed the conversion. An experienced financial advisor can help you convert funds during years when you have less income, to avoid bumping yourself into a higher tax bracket.
| Advantages | Disadvantages |
|---|---|
| Can be done before age 59½ | Taxes due upon conversion |
| Can provide a tax-free inheritance for heirs | Not simple; requires detailed planning |
| May help you with tax diversification while in retirement | Certain heirs still subject to the 10-year rule |
Do note, though, that this type of conversion only applies to spouse beneficiaries as long as they take the IRA as their own first—then they can convert it to a Roth IRA. This is not allowed for non-spouse beneficiaries.
2. Convert to a Life Insurance Policy
Another option is to take a distribution from your IRA or 401(k) to purchase a life insurance policy. This can provide a tax-free death benefit for your beneficiaries while reducing the size of your retirement account or IRA, thus helping to minimize the taxable inheritance your loved ones receive.
Plus, this approach doesn’t have the 10-year distribution requirement that comes with the Roth strategy. You can choose to have the death benefit distributed directly to your beneficiaries in a lump sum, or you could name a trust as beneficiary and include stipulations for when and how it’s distributed.
Consult with an experienced wealth advisor before implementing such a strategy, as life insurance becomes more expensive as you age.
| Advantages | Disadvantages |
|---|---|
| Straightforward and easy to implement | May not be affordable, or possible, with advanced age or health issues |
| Can provide a tax-free inheritance for heirs | Must ensure you have enough retirement savings to use for life insurance premiums |
| Not subject to the 10-year distribution requirement |
3. Use Qualified Charitable Distributions (QCDs)
While this strategy doesn’t directly benefit your heirs, a QCD can help draw down your accounts in a tax-advantaged manner. Making a qualified charitable distribution satisfies your annual RMD from your retirement accounts.
You can start making QCDs as soon as you reach age 70½, with a maximum annual contribution of $110,000. You won’t get to deduct these gifts on your tax return, but you also won’t need to report them as taxable income the way you would with a standard distribution.
| Advantages | Disadvantages |
|---|---|
| Can be done each year to satisfy your annual RMD after age 70½ | You’ll have less to leave to your heirs |
| Simple and straightforward | Doesn't affect the 10-year payout rules for heirs |
| Offers a tax-beneficial way to give to charity while offsetting your own tax obligation |
4. Establish a Charitable Remainder Trust (CRT)
Charitable remainder trusts (CRTs) can also provide a potential benefit under the new rules. A CRT is an irrevocable trust that generates a potential income stream for you, as the donor to the CRT, or other beneficiaries, with the remainder of the donated assets going to charity. Here are two ways you can use a CRT to help reduce taxable income:
- Lifetime CRT: You can choose to transfer your 401(k) or IRA into a CRT while you’re still alive and have it pay out to you during your lifetime. After you pass away, those income payments would then be made to your named beneficiaries. Upon their death or at the end of the stated term, the remaining assets would pass to your chosen charity. In terms of tax obligations, you would initially receive a deduction for the gift, but you would have to report the income received back from the trust.
- CRT as your beneficiary: You would name the CRT as the beneficiary of your IRA or 401(k) account. After your death, the CRT would pay out to the CRT income beneficiaries for the term of the trust, which could be their lifetime or a set amount of time, no longer than 20 years.
In both scenarios, the trust would be obligated to pay your heirs over their lifetime or no more than 20 years, surpassing the 10-year payout under current inherited IRA required minimum distribution rules.
| Advantages | Disadvantages |
|---|---|
| Flexibility to start while you're still alive or upon your death | Requires detailed planning and execution |
| Provides an inheritance for your heirs that can be spread out over time | You'll have less to leave to your heirs (vs. not using a CRT) |
| Offers the ability to leave money to charity and your heirs | Upfront costs for legal and administrative setup can be high |
| Provides a stream of income for you or your beneficiaries | Irrevocable decision; once funded, terms cannot be changed |
Work with a Financial Advisor to Navigate Inherited IRA RMDs
Inherited IRA RMD rules are intricate, and a misstep can result in significant tax penalties for you or your heirs. The strategies we’ve discussed—from Roth conversions to charitable trusts—can be powerful tax strategies when it comes to retirement planning, but they’re also highly complex. A trusted financial advisor can help translate these complex regulations into a clear, personalized plan. This helps ensure you remain compliant with the IRS while optimizing the legacy you intend to leave. To build a comprehensive strategy for your estate, talk to a Carson Wealth advisor today.
FAQs
Can you cash out an inherited IRA?
Yes, but cashing out an inherited IRA may create a significant tax liability.
Do inherited Roth IRAs have RMDs?
Yes, inherited Roth IRAs have RMDs, but the withdrawals are typically tax-free.
What happens if you miss an inherited IRA RMD?
If you miss an inherited IRA RMD, you face a steep 25% penalty on the amount not withdrawn.
Are inherited IRAs grandfathered under the SECURE Act?
IRAs inherited before January 1, 2020, are grandfathered under the SECURE Act, allowing certain eligible designated beneficiaries to use the old “stretch” rules. Talk to a trusted financial advisor for advice on your specific scenario.
This article is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.
The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of an experienced estate planning professional before implementing such strategies. There is no assurance that any investment strategy will be successful. Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 1/2, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers free tax withdrawals on taxable contributions. To qualify for the tax-free and penalty free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 1/2 or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes. Converting from a traditional IRA to a Roth IRA is a taxable event.
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