Inheriting an IRA as a Non-Spouse Beneficiary is Now More Complicated!

By S. Joseph DiSalvo and Marie L. Madarasz

Pre-tax retirement accounts are a fairly new retirement planning tool, all things considered. It wasn’t until 1975 that the traditional individual retirement accounts (IRAs) first became available. And in 1981 the Internal Revenue Code enacted rules that allowed employees to contribute to their 401(k) plans through salary deductions, which jump-started the widespread roll-out of 401(k) plans in the early 1980s.

In the 30+ years that these accounts have been in use, both their popularity and their balances have grown. It is not uncommon to see balances in these accounts well over a million dollars. What has also grown is the complexities of inheriting these accounts, particularly for non-spousal beneficiaries, and as the U.S. population ages it is now more common than ever to inherit a pre-tax retirement account from your mother or father, another family member, or a friend.

What has changed with the SECURE Act?

The SECURE Act, which became effective on January 1, 2020, includes several provisions that affect distribution rules for inherited retirement accounts (IRAs, 401(k)s, etc.). The most impactful change is the partial elimination of the “stretch IRA.” Starting in 2020, for IRAs passing to most non-spouse beneficiaries, the entire retirement account balance must be distributed by the end of the 10th year following the year after the owner’s death. Prior to the SECURE Act, most beneficiaries had the option of stretching their required minimum distributions out over their lifetime, allowing more of the pre-tax money to stay invested and grow. Post SECURE Act, for most non-spouse beneficiaries, the 10 year pay-out rule is in place with these exceptions: you are a minor child (NOT a grandchild) of the original owner; are not more than 10 years younger than the original owner; or you are disabled/chronically ill as defined by the Internal Revenue Code. If you inherit an IRA or 401(k) from your spouse, nothing really changes. You can still generally stretch out required minimum distributions (RMDs) over your lifetime.

The stakes have never been higher to get the rules right!

Stop! Consider all of your options before you do anything. Although you are able to do so, do not take a full distribution of an inherited retirement account unless you are sure that is what you want to do. The traditional IRA and 401(k) (NOT a Roth) will most likely be 100% pre-tax, meaning tax has never been paid on any of it. Uncle Sam has been waiting for his share for decades! Therefore, this distribution will be a taxable event which cannot be undone.

For example, let’s say you inherit a $1,000,000 pre-tax traditional IRA from your father and opt for a full distribution or fail to follow the various rules and regulations that govern these accounts. Your taxable income is now increased by $1,000,000, potentially causing you to lose more than a third of your inheritance (and your father’s hard earned money) to Uncle Sam.

There are other differences for non-spouse beneficiaries beyond distributions rules. Often people think they can roll an inherited IRA into their own IRA. However, if you inherited an IRA from someone who is not your spouse you cannot roll the account into your own IRA or treat the IRA as your own. Instead, you should establish a properly titled Inherited IRA account, i.e., Bob Jones, deceased, IRA, FBO Joan Jones, beneficiary. It must name the original account owner in the title and indicate that it is an inherited IRA. Correct titling is very important! Once this account is established you can do a direct transfer, NOT a 60-day rollover. Meaning, a direct transfer from custodian to custodian is completed with the check made payable to your new custodian “for the benefit of you,” not to you directly.

What are the planning considerations under this 10-year payout scenario?

If you have an inherited IRA received from a loved one prior to 2020, nothing changes for you. The old “stretch” rules still apply.

Those who inherit a retirement account in 2020 or after should think through the impact of the new 10-year rule and discuss options with their financial advisor. Although the timeframe for a full distribution is condensed, you will have significant flexibility in how to access the IRA over the 10-year period. There are no longer any annual withdrawal requirements. Some people may be comfortable with the new shortened timeframe. On the other hand, larger, more condensed withdrawals can push inherited-IRA owners into higher tax brackets and some may want to be more strategic with their planning. There may be opportunities to space the withdrawals out in such a way that sends less tax dollars to the government.

Keep in mind that the money cannot stay in the account after the 10 years. If you fail to empty out the inherited IRA within the 10-year payout period, a 50% penalty will be imposed on the shortfall. This rule also applies if you have inherited a Roth IRA, although any inherited Roth IRA distributions will not be taxable.

With people inheriting pre-tax retirement accounts with balances higher than we have ever seen and the complex rules that govern them, the stakes have never been higher to understand the pitfalls and opportunities available and how best to proceed given their individual financial circumstances.

About the authors: S. Joseph DiSalvo, ChFC® and Marie L. Madarasz, AIF®

S. Joseph DiSalvo, ChFC®, and Marie L. Madarasz, AIF®, authors of Income for Life, a Retiree's Guide to Creating Income from Savings, are experts specializing in all aspects of retirement income planning including the coordination and integration of their clients' income, investment, and tax planning strategies. They are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity. www.IncomeForLifeBook.com