You're likely to inherit an individual retirement account during one of the worst times in your life: when a loved one passes away. But even during this difficult time, it's important to pay attention to the inherited IRA rules and deadlines so you can best avoid taxes and penalties on the inheritance your family member left behind.
Here's how to make the most of an inherited IRA:
-- Remember the first required minimum distribution.
-- Pay attention to the 10-year rule for inherited IRA distributions.
-- Find out if you qualify for an exception to the 10-year rule.
-- Take care to minimize taxes.
-- Label the account correctly.
-- Consider separating accounts.
Remember the First Required Minimum Distribution
If the deceased owner of the IRA account has already been taking retirement account distributions, you must continue that distribution schedule until the end of the calendar year. "If dad was taking distributions, you have to make sure that dad takes his final distribution in the year of his death, otherwise there is a 50% penalty on the amount he was supposed to take," says Joseph Harowski, a certified financial planner and president of Smart Choice Financial Planning in St. John, Indiana. Income tax will be due on each traditional IRA withdrawal.
The 10-Year Rule for Inherited IRA Distributions
If the IRA owner died on or after Jan. 1, 2020, you may be required to withdraw the entire account balance within 10 calendar years of the account owner's death and pay income tax on each distribution. "There is no requirement for how much you need to take in each of those 10 years," says Leah Coleman, a certified financial planner and founder of Orchard Financial Group in Austin, Texas. "You could distribute all at once or take a little each year, but the account must be empty by the end of the 10th year following the year of inheritance."
Exceptions to the Inherited IRA 10-Year Rule
There are several exceptions to the IRA 10-year rule, including for a surviving spouse, minor child, disabled or chronically ill beneficiary, or a beneficiary who is within 10 years of age of the original IRA owner. These beneficiaries may be able to receive more time to draw down the account and pay the resulting tax bill.
For example, when you inherit an IRA from a spouse, you can transfer the IRA balance into your own account and delay distributions until after you turn age 72. "Surviving spouses can simply roll the IRA into their name and treat it as their own," says Patrick Dinan, a certified financial planner and president of Impact Fiduciary in Glendale, California.
Minor children must start required minimum distributions from an inherited IRA, but don't become subject to the 10-year rule until they reach the "age of majority," which is 18 in most states. Disabled beneficiaries and those within 10 years of age of the original account owner have the option to stretch required withdrawals over their lifetime.
Minimize Taxes on Inherited IRA Distributions
The timing of your inherited IRA distributions will determine how much tax is due on withdrawals from the account. For some people, it can be a smart tax move to gradually draw down the account over the 10-year period to avoid a large tax bill in a single year and potentially being bumped into a high tax bracket.
"For a typical W2 employee, this may mean taking small distributions annually until the inherited account has been fully liquidated," says Nick Foy, a certified financial planner and founder of Greenway Wealth Advisors in Charlotte, North Carolina.
However, you could also reduce your inherited IRA tax bill by withdrawing the bulk of the funds during a low earning year. Coleman says, "If you will have some years of lower income, plan to take the distributions in those years. For example, if you were going to retire in five years, wait to start distributing from the account until you are retired. This gives you five years to distribute the account at a potentially lower tax bracket."
Label the Account Correctly
The money in an inherited IRA can be moved to a new financial institution without incurring taxes or penalties if you make a trustee-to-trustee transfer into another IRA that is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. You will need to take distributions from the new IRA using the same beneficiary distribution rules as under the old IRA.
Consider Separating Accounts
If an IRA account has multiple beneficiaries, an IRA can be split into separate accounts for each beneficiary. Splitting the account allows each individual beneficiary to decide how to invest the proceeds. It can be especially beneficial to separate accounts if one or more of the beneficiaries qualifies for one of the exceptions to the 10-year withdrawal rule.