Inherited IRAs -Understanding your options

By VWG Wealth Management on September 30, 2022

Contributing editor, Joseph Coyne, CPA, CFP®

When you inherit assets from a deceased loved one, the litany of tasks and choices that can follow — during what is likely an already difficult time in your life — may seem overwhelming. Different account types require different considerations and actions; and the accompanying rules, terminology and tax implications can be difficult to navigate.

Inherited individual retirement accounts (IRAs) are no exception. To help you navigate rules and next steps, here are answers to questions that may arise if you are the beneficiary of retirement assets.   

What are the options when you inherit a traditional IRA from your spouse?

Generally, you have two main options:

1. Treat it as your own IRA by either:Designating yourself as the account owner; or
   • Transferring the assets into a new or existing IRA, or to the extent it is taxable, into qualifying retirement plans (e.g., 401K, 403(a) and (b), etc.)
2. Treat yourself as the beneficiary by either:
3. Transferring the assets into an inherited IRA; or
   • Taking a lump sum distribution

Most spouses who are the sole beneficiary chose option one — to treat the assets as their own — but every individual’s situation is unique and requires careful consideration.

What are the differences between spouses’ options for traditional IRAs?   

What are your options when you inherit an IRA from someone other than your spouse?

It depends on what type of designated beneficiary you are — eligible or noneligible. To be considered eligible you must be a surviving spouse, a disabled individual, a chronically ill individual, a minor child or an individual who is not more than 10 years younger than the account owner.  

If you are a non-spouse eligible designated beneficiary, you can’t treat the IRA as your own. But you can open an inherited IRA account. You could take a lump sum distribution or spread your distributions out using the life expectancy rules related to each category of eligible designated beneficiaries. The rules and considerations are similar to those for spouses — albeit with certain nuances, so you should coordinate carefully with your advisors.

If you are not an eligible designated beneficiary, you must withdraw the entire account by the 10th calendar year following the year of the IRA owner’s death and pay any income tax associated with the distribution payout.[i]

I’ve seen inherited IRAs in the news lately. Why? What has changed?

The rules for inherited IRAs changed with the 2019 SECURE Act, which included a new 10-year payout rule for non-spousal, noneligible designated IRA beneficiaries. Previously, these individuals could spread out withdrawals over their lifetime (often referred to as “stretch IRAs”).

The new 10-year payout rule was interpreted by many to mean that these beneficiaries — often children of the deceased — could wait until year 10 before taking any withdrawals. But in February 2022, the IRS proposed new rules that would require these beneficiaries to take annual withdrawals in cases where the deceased died on or after needing to begin taking their RMDs. In many instances, this would mean that working beneficiaries would inherit — and be subject to taxes on — assets during higher-income periods in their life, leading to larger tax bills than if they could wait 10 years.

Certain taxpayers and industry groups, including the American Institute of Certified Public Accountants, have urged the IRS to eliminate the annual distribution requirement for people who have inherited money since 2019, when the SECURE Act eliminated “stretch IRAs.” The IRS in turn has said it is reviewing comments and will respond to them in final rules.[i]

What if I inherit a Roth IRA?

If you inherit a Roth IRA, your options and the rules around them are similar to those for traditional IRAs, depending on the type of beneficiary you are — spouse, non-spouse, eligible designated beneficiary, etc. Surviving spouses can treat it as their own (and have the added benefit of not needing to take RMDs on Roth IRAs), whereas other beneficiaries must transfer the assets into an inherited Roth IRA or take a lump sum payment. Further, all beneficiaries who are not eligible designated beneficiaries (i.e., spouses, minor children of the deceased, those who are disabled or chronically ill, and those who are not more than 10 years younger than the deceased) must distribute all of the assets within 10 years of the original owner’s death.

The main difference, however, is the way Roth IRA distributions are taxed, which applies to Roth IRAs across the board, whether inherited or not. Distributions generally are not taxed so long as they meet certain requirements, including a five-year holding period (for inherited IRAs, beginning when the deceased opened the account).

Can I convert a traditional IRA I inherited into a Roth IRA?

Only if you are the spouse of the deceased. This is accomplished by treating it as your own and then converting the assets into a Roth IRA. Other types of beneficiaries do not have this option.

Generally speaking, Roth conversions may make sense in scenarios where your income tax rate is relatively low (e.g., in retirement), when asset prices are depressed and/or if you don’t expect to need your Roth IRA assets during your lifetime. Taxes are paid up front on the conversion, in exchange for the benefit of not having taxes taken out in later years, when tax brackets may be higher.

This is complicated. How can I make this decision/process easier?

Talk to a financial advisor, who can coordinate with your accountant to help you identify the right option and next steps for your unique situation.

We are here to help. If you or someone you know needs help managing inherited assets, please reach out to us.  

[i] Assuming the death occurred after 2019. The SECURE Act of 2019 changed the distribution rules for inherited IRAs and other retirement plans by eliminating the life expectancy payout (“stretch IRA”) for most beneficiaries.

[ii] Ebeling, Ashlea, “IRS Changes Guidelines for Inherited IRAs, Causing Confusion and Pushback,” The Wall Street Journal, https://www.wsj.com/articles/irs-changes-guidelines-for-inherited-iras-causing-confusion-and-pushback-11659309278. Accessed August 12, 2022.

Disclosures

VWG Wealth Management is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment advisor. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC. All information referenced herein is from sources believed to be reliable. VWG Wealth Management and Hightower Advisors, LLC have not independently verified the accuracy or completeness of the information contained in this document. VWG Wealth Management and Hightower Advisors, LLC or any of its affiliates make no representations or warranties, express or implied, as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. VWG Wealth Management and Hightower Advisors, LLC or any of its affiliates assume no liability for any action made or taken in reliance on or relating in any way to the information. This document and the materials contained herein were created for informational purposes only; the opinions expressed are solely those of the author(s), and do not represent those of Hightower Advisors, LLC or any of its affiliates. VWG Wealth Management and Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax or legal advice. Clients are urged to consult their tax and/or legal advisor for related questions.