Reading through so many women’s Home Economics submissions, you start to see trends and recurring themes that pop up time and again. One of the most common, especially for women in their 30s and above, is what, exactly, to do with an inherited IRA.
When a parent or spouse (or other close friend or family member) dies, you, as their beneficiary, might inherit their retirement accounts, often in the form of an individual retirement account, or IRA. While few people would complain about receiving a bit of extra money, the rules for what happens next can be a little complicated—and that can cause a lot of headaches.
To add to the confusion, the rules for taking withdrawals, as well as the tax treatment for the withdrawals, often changes based on the whims of the current Congress and the tax laws it manages to pass. Most recently, Congress rubber stamped the Secure Act 2.0, which made a number of changes related to inherited IRAs.
I chatted with Hannah Quinton, a certified wealth strategist with Charles Schwab, to get a better sense of what all inheritors need to know.
Before we get too deep into the weeds, a fair warning: As with anything and everything to do with the IRS and taxes, exactly what you'll need to know will depend on your individual financial situation, including income, age, and relationship to the deceased. There are countless variables to consider.
Or as Quinton put it: "There's no cookie cutter, straightforward approach.”
So if you inherit a significant amount of money, it might be worth scheduling an appointment with a certified financial planner, accountant, or investment manager (if you don't already have one).
Below are some general guidelines to get you started.
What is an inherited IRA?
An inherited IRA is also known as a beneficiary IRA, and it is a type of investment account that is opened when someone inherits an IRA, 401(k), or 403(b) after the original account owner dies.
Beneficiaries can't make any more contributions to that account, but they can hold onto the investments or make (generally) penalty-free withdrawals. As I mentioned above, the Secure Act 2.0 changed some of the rules related to inherited IRAs. So what I'm writing about applies to situations where the original IRA account holder died after 2019 (meaning from Jan. 1, 2020 to present day).
Many beneficiaries, including adult children, are required to draw down the account by the end of the 10th year following the death of the original owner. Others—primarily surviving spouses—don't necessarily need to worry about that rule.
These rules are specific to inherited IRAs. If you instead transfer the IRA to your own IRA, then you don't need to spend it down in 10 years. But, assuming you’re not at retirement age (59 ½), you also can’t transfer it to your own account and also make withdrawals without incurring penalties.
Withdrawal rules depend on your relation to the deceased
Generally speaking, beneficiaries need to spend down the account within 10 years of the original owner's death. For example, if your grandfather passes and leaves you $10,000 in an IRA, you are at least 21, and you transfer those funds to an inherited IRA, you will need to liquidate the account over the course of the next 10 years.
This is a change. Before 2020, many beneficiaries opted for a "stretch" strategy, taking minimal distributions over the course of their lifetime.
There are some exceptions to the 10-year rule. Spouses, for one, don't necessarily need to worry about that window if you transfer the assets into an inherited IRA held in your name. Instead, withdrawals can be spread over your life expectancy.
Of course, there's another catch there: If the deceased started taking required minimum distributions—or RMDs—from their account before they died (or would have been required to the year they died), the inheritor will need to continue to take those withdrawals.
While you might not have wanted to take a distribution until the 10th year, unfortunately, you will have to take at least the RMD each year. (This also holds true for spouses.) The RMD age is currently 73.
Minor children are also exempt from the 10-year rule until they turn 21. Then they also need to liquidate the account over the next decade.
There are many other scenarios and exceptions to the rules. For example, there are different rules for chronically ill and disabled beneficiaries, as well as those who are not a spouse but are less than 10 years younger than the deceased. Schwab has a good breakdown of all of these different circumstances here.
You can see why it might be good to talk to a tax professional about the options.
The tax implications of an inherited IRA
A traditional IRA generally holds tax-deferred contributions, which means when you withdraw funds, you need to pay taxes.
That can make the 10-year window tricky. If your income varies, you might want to plan to take higher withdrawals in a year when it's on the lower end, to pay less tax.
"A lot of times people are inheriting the wealth in the IRA during their prime income years, so all of a sudden the tax burden becomes significant" says Quinton. "Let's say you wait to take a distribution because you don't want to go up a tax bracket, then all of a sudden, at that tenth year, you have to take a lump sum. Well, that really puts you over."
Look at it this way: Let's say you're 40, and your father, who hadn’t yet reached RMD age, leaves you a $500,000 pre-tax IRA. You probably don't want to wait until the 10th year to take the entire distribution, even though the investments could theoretically keep growing in value. It likely makes more sense to stretch out the withdrawals over the 10 year window.
Spouses have more options
Spouses of the deceased have more options than other types of beneficiaries. For example, upon the death of the original account owner, the spouse could choose to take a lump sum distribution, instead of the headache of opening an inherited IRA or rolling it over into their own.
Of course, they'll owe taxes on the lump sum distribution, which could be quite costly. Depending on the amount and current income level, it could move you up into the next tax bracket. Another reason some money managers advise against this option is because if you leave the funds invested in the account, they can continue to grow, tax-deferred.
Still, taking a lump sum distribution is a potentially good option for someone who could use the cash infusion. Or you can stick with annual distributions if that’s your preference.
What about a different type of inherited retirement account?
Of course, not every inherited account is an IRA. Take the 41-year-old furloughed federal employee who inherited a 403(b) account from her father worth $215,000.
A 403(b)s is a retirement plan offered by public schools and certain 501(c)(3) tax-exempt organizations.
The rules here are similar to inherited IRAs—and similarly complicated. For example, spousal beneficiaries could choose to maintain the 403(b) plan and make regular withdrawals, move the assets to their own 403(b), roll over the assets into their own IRA, or take a lump-sum withdrawal.
The withdrawal rules also differ for Roth IRAs. Because Roths are funded with money that’s already been taxed, you won’t owe taxes on any distributions, which makes the process a little easier, though you will still need to empty the account within 10 years.
What to do with your own retirement accounts
If all of this is making you think about who might inherit your retirement accounts one day, it's worth taking the time to check the designated beneficiaries on your retirement accounts (and other financial accounts, too).
Some things to know: Who you name as a beneficiary on your IRA supersedes other estate planning documents, including your will. So you want to be careful—and you want to make sure it’s up-to-date. If your will and IRA have differing beneficiaries, the IRA instructions win out.
If you don’t have someone designated, the IRA will go to your spouse in the event of your death. If you’re not married at the time of your death, it goes to your general estate.
You can name anyone as a beneficiary. You can also split up the account to go to multiple people by designating them different percentages. (For example, 20% to each of your two children and the remaining 60% to your spouse.) You can also name a non-person entity like a trust or charity as the beneficiary.
Not keeping beneficiaries up-to-date is one of the biggest mistakes Quinton says she sees people routinely make. You don’t have to name a specific person. You could simply designate “the person I am married to at the time of my death” as the beneficiary, or “my descendants” (meaning your children split the assets equally, or if a child has died, their children will).
“I've had cases where, especially with more senior folks, their beneficiaries are deceased, or their trustees are no longer around. Things change really quickly,” Quinton says. “So, we recommend that you review your trust documents every three to five years.”
It's also worthwhile to make sure your beneficiaries know, at a minimum, what financial accounts you have and how to access them, says Quinton. Most people avoid these conversations because they can be uncomfortable, but talking to your beneficiaries—whether your spouse, children, siblings, etc.—ensures everyone's on the same page.
And as women are set to inherit more wealth than ever before in history, having these conversations is increasingly important.
