In 2023, the total value of IRAs in America surpassed $12 trillion. With diligent savings, many individuals hope to pass on a significant portion of these funds to their heirs. However, recent legislative changes and IRS interpretations might mean a larger tax bill for beneficiaries. Here’s what you need to know about inherited IRA regulations.
The Pre-2020 Era: Stretching Out Inherited IRAs
Before 2020, beneficiaries of traditional IRAs could reduce their tax liabilities by spreading withdrawals over their life expectancy. This allowed for a strategic approach to minimize taxes over an extended period.
The SECURE Act’s Impact on Inherited IRAs
The SECURE Act, enacted in 2019, altered this landscape. For most non-spouse heirs inheriting a traditional IRA post-January 1, 2020, the options are limited:
- Take a lump sum, incurring taxes on the entire amount.
- Transfer to an inherited IRA, which must be emptied within a decade of the original owner’s passing.
For clarity, if an IRA was inherited in 2020, it should be fully withdrawn by December 31, 2030.
Roth IRAs: A Slightly Different Story
The 10-year rule also applies to inherited Roth IRAs. However, beneficiaries aren’t taxed on withdrawals or mandated to take required minimum distributions (RMDs). This offers a decade of potential tax-free growth.
IRS Guidance and Its Implications
The IRS’s 2022 guidance added nuances. If the original IRA owner passed away before their RMDs began, beneficiaries could withdraw any amount if the account is emptied by the 10th year. However, suppose the owner died after RMDs started. In that case, beneficiaries must follow a schedule based on their life expectancy for the first nine years and deplete the account in the 10th year.
Penalties and Planning Ahead
The IRS has relieved penalties for missed RMDs for tax years 2021, 2022, and 2023. However, starting in 2024, beneficiaries must be vigilant. Missing a distribution can result in a hefty 25% penalty on the amount that should’ve been withdrawn.
Strategies for Beneficiaries
Beneficiaries should consider:
- Calculating RMDs using the IRS Single Life Expectancy Table.
- Strategically planning withdrawals to avoid jumping tax brackets.
- Consulting with financial planners to optimize tax implications over the ten years.
Managing Your Inherited IRA
Beneficiaries must establish an inherited IRA account. Direct transfers (trustee-to-trustee) are essential to avoid immediate taxation. Once set up, beneficiaries can invest based on their financial goals.
Spousal Inheritance: More Flexibility
Spouses inheriting IRAs have more options, including treating it as their own IRA, rolling it into their existing IRA, or transferring to an inherited IRA. Each choice has its tax implications and benefits.
Leaving a Tax-Efficient Legacy
For those planning their estates, converting a portion of traditional IRAs to Roth IRAs can be a tax-efficient strategy for heirs. While non-spouse heirs must deplete a Roth within ten years, withdrawals are tax-free, offering a decade of tax-free growth.
The Bottom Line
The landscape for inherited IRAs has shifted. Beneficiaries and those planning their legacies must stay informed and strategize to optimize tax benefits. Consulting with financial experts can provide clarity in this evolving domain.