Inheriting an individual retirement account (IRA) from a parent can be a significant financial event, but it comes with a specific set of rules that must be navigated carefully. For those who recently inherited their father’s IRA, understanding these regulations is essential to manage the account properly and avoid unexpected tax liabilities.
Understanding Inherited IRAs
Many individuals mistakenly believe they can roll an inherited IRA into their own account. However, this is generally not permitted for most beneficiaries. When you inherit an IRA from a parent or sibling, the funds must be transferred into a newly established inherited IRA, which must be titled in the deceased owner’s name. For example, it would read: John Smith, deceased, for the benefit of Jane Smith.
If the deceased had multiple beneficiaries, the account can be split into separate inherited IRAs. This allows each beneficiary to manage their withdrawals independently, as if they were the sole recipient of the account. To set up an inherited IRA, beneficiaries can typically do so at most banks or brokerage firms, though it is often simplest to establish the account with the institution that held the original IRA.
Withdrawal Requirements Under the SECURE Act
The SECURE Act, which became law in December 2019, introduced a key rule regarding the withdrawal of funds from inherited IRAs. Most non-spouse beneficiaries are required to withdraw all assets from the inherited IRA by the end of the tenth year following the original owner’s death. This rule applies if the account owner died in 2020 or later.
If the deceased had begun taking required minimum distributions (RMDs), the beneficiaries must continue taking these annual withdrawals while also ensuring the account is emptied within the ten-year timeframe. Should the deceased not have started taking RMDs, there are no annual withdrawal requirements, provided the entire IRA balance is withdrawn by the end of the ten-year period.
It is important to note that withdrawals from a traditional IRA are taxed as ordinary income in the year they are taken. Conversely, distributions from a Roth IRA are usually tax-free, assuming the account has been open for at least five years. Failing to take an RMD, or withdrawing insufficient amounts, can lead to a penalty of 25 percent of the amount that should have been withdrawn. This penalty can be reduced to 10 percent if corrected within two years.
Exceptions and Tax Strategies
Some beneficiaries are exempt from the ten-year withdrawal rule, including surviving spouses, minor children, disabled or chronically ill individuals, and those within ten years of age of the original IRA owner. These beneficiaries may have the option to stretch their withdrawals over a longer period.
While it may be tempting to cash out an inherited IRA or take large withdrawals quickly, this approach can lead to substantial tax implications. Withdrawals from a traditional IRA are taxed at the recipient’s regular income tax rate. For many beneficiaries, spreading distributions over the ten-year period can help manage tax liabilities and minimize the risk of being pushed into a higher tax bracket.
Given the complexity of these rules and the potential financial impact, it is advisable for beneficiaries to consult with a qualified financial adviser. They can provide guidance tailored to individual circumstances, ensuring that the inheritance is managed effectively and in compliance with all regulations.
