Understanding Your Options as a Beneficiary of an Inherited IRA

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Individual Retirement Accounts (IRAs) are a great way to accumulate assets in a tax-advantaged account. However, when the original owner of an IRA has passed away, there are a new set of rules that guide how and when account distributions must occur. If you are a named beneficiary for an IRA, you need to fully understand your options so that you can make a decision that is the best one for your overall financial life plan.

What a Beneficiary Distribution Account Is

A Beneficiary Distribution Account, or BDA, is another name for an Inherited IRA. When you inherit an IRA, there are a special set of tax rules that determine annual distributions you must take. With an Inherited IRA, you will have to take annual distributions regardless of how old you are at the time your account was established. In general, those distributions must take place during your lifetime or within five years after the original account holder passed away.

Here is an overview of your withdrawal options and tax consequences when inheriting an IRA as a non-spouse beneficiary. If you are the surviving spouse of the original IRA account owner, there are a separate set of rules regarding what may be done with an inherited IRA (see Tax Consequences If You’re a Surviving Spouse).

If you are a non-spouse beneficiary, you have different options to choose from depending on the type of IRA account you are inheriting (Traditional IRA, Roth IRA, etc.) and the age of the account holder.

Options for Someone Who Inherited a Traditional, Rollover, SEP, or Simple IRA and the Account Holder Was Over 70 ½

Lump Sum DistributionThis option does not require you to set up a separate account as all of the money in the IRS is distributed to you. You will pay income taxes on the distribution all at once. While you will not incur the 10 percent early withdrawal penalty if you are under age 59 ½ you will still have to pay income taxes on the distribution. This has the possibility of creating some tax issues because the distribution may potentially move you to a higher tax bracket. Deciding if a lump sum distribution makes sense for you ultimately depends on the amount of the distribution, your current income level.

It also depends on whether other tax-deferral strategies make more sense.

Inherited IRA With the Life Expectancy Method: Opening an Inherited IRA with the life expectancy method allows you to transfer the assets into an account held in your name. This is where the “Beneficiary Distribution Account” has special rules to pay attention to. You must begin taking annual required minimum distributions (RMDs) over your life expectancy beginning no later than the of the year following the original account holder's death. However, if the account owner did not take their required minimum distribution in the year of death, RMDs must be taken by the end of the year the original account holder died.

Once RMDs begin in the Inherited IRA, those annual distributions may be spread over whichever option is longer, your single life expectancy (determined by your age in the calendar year following the year of death and reevaluated each year) or the original account owner’s remaining life expectancy. In the event the account holder named multiple beneficiaries, separate accounts would need to be established by December 31 of the year following the year of death. Otherwise, distributions will be based on the oldest beneficiary.

Required Minimum Distributions (RMDs) are mandatory, and you will be taxed on each distribution. However, you will not be faced with the 10 percent early withdrawal penalty. Another benefit is that assets remaining in the account can continue to grow on a tax-deferred basis. Finally, you also may elect to designate your own IRA beneficiary or multiple beneficiaries for your Inherited IRA.

Options for Someone Who Inherited a Traditional, Rollover, SEP, or Simple IRA and the Account Holder Was Under 70 ½

Lump Sum DistributionThis option does not require you to set up a separate account as all of the money in the IRS is distributed to you. You will pay income taxes on the distribution all at once. While you will not incur the 10 percent early withdrawal penalty if you are under age 59 ½ you will still have to pay income taxes on the distribution. This has the possibility of creating some tax issues because the distribution may potentially move you to a higher tax bracket. Deciding if a lump sum distribution makes sense for you ultimately depends on the amount of the distribution and your current income level.

It also depends on other tax-deferral strategies make more sense.

Inherited IRA With the Life Expectancy Method: Opening an Inherited IRA with the life expectancy method allows you to transfer the assets into an account held in your name. This is where the “Beneficiary Distribution Account” has special rules to pay attention to. You must begin taking annual required minimum distributions (RMDs) over your life expectancy beginning no later than the of the year following the original account holder's death. However, if the account owner did not take their required minimum distribution in the year of death, RMDs must be taken by the end of the year the original account holder died.

Once RMDs begin in the Inherited IRA, those annual distributions may be spread over whichever option is longer, your single life expectancy (determined by your age in the calendar year following the year of death and reevaluated each year) or the original account owner’s remaining life expectancy. This option is often referred to as a Stretch IRA because of the ability to extend distributions over your life expectancy while still having the ability to take out more than the RMD if desired.

In the event the account holder named multiple beneficiaries, separate accounts would need to be established by December 31 of the year following the year of death. Otherwise, distributions will be based on the oldest beneficiary. Required Minimum Distributions (RMDs) are mandatory, and you will be taxed on each distribution. However, you will not be faced with the 10 percent early withdrawal penalty. Another benefit is that assets remaining in the account can continue to grow on a tax-deferred basis.

Finally, you also may elect to designate your own IRA beneficiary or multiple beneficiaries for your Inherited IRA.

Inherited IRA With the 5-Year Method: Choosing this option also involves transferring assets into an Inherited IRA in your name. The 5-year rule for non-spouse beneficiaries allows you to withdraw all of the funds from the IRA by December 31 of the fifth year following the IRA account owner's death. This doesn’t have to be done on an installment basis, but you must withdraw all of the funds before the applicable date at which point the entire account must be depleted. Each distribution will be treated as taxable income.

Remaining assets continue to grow tax-deferred for up to five years giving you some flexibility if you choose this option.

Options for Someone Who Inherited a Non-Spousal Roth IRA

Lump Sum Distribution: Similar to Traditional IRA rules, the lump sum option does not require you to set up a separate account as all of the money in the IRS is distributed to you. Roth IRAs allow for tax-free withdrawals of earnings for the original account owner as long as the account is at least 5 years old and the original owner is at least 59 ½. Beneficiaries of a Roth IRA may receive all assets in the Roth IRA as a lump sum distribution, and there are no age restrictions. These distributions will be tax-free unless the account is less than five years old at the time of the original account holder’s death.

In that case, earnings are considered taxable income.

Inherited IRA with the Life Expectancy Method: Roth IRAs have a unique feature in that they do not have RMDs during the original account owner’s lifetime. Inherited Roth IRAs have mandatory RMDs, and those distributions must begin no later than December 31 of the year following the account owner’s death. The good news is that distributions may be withdrawn without being taxed as long as the original owner met the five-year holding period. RMDs are spread over the single life expectancy of the beneficiary.

In the event, there are multiple beneficiaries separate accounts must be established. If not, distributions will be based on the life expectancy of the oldest beneficiary. There are no 10 percent early withdrawal penalties, and assets within the account continue to grow tax-free. You can even choose to designate your beneficiaries.

Inherited IRA With the 5-Year Method: Choosing this option with a Beneficiary Distribution Account gives you up until the end of the fifth year after the original account owner’s death. At that point, the entire Inherited IRA must be fully distributed. While distributions may be spread out over time, the length of time is much shorter than the life expectancy method. Setting up an Inherited IRA in your name gives you the ability to name your beneficiary, and you can still allow those assets to grow tax-free for up to five years.

In summary, Beneficiary Distribution Accounts (Inherited IRAs) give you the ability to have more flexibility and control over when to receive inherited assets. In the event, a friend or family member has chosen you as a beneficiary of their Traditional or Roth IRA, be sure you carefully review your options and how they fit into your overall financial plan.