Inherited IRA Rules That Can Surprise and Trap Heirs
Congress and the IRS made inheriting an IRA a very complicated, confusing event.
Inherited IRAs are accompanied by a host of little-known rules that are traps for the unwary, and that’s before considering the end of the Stretch IRA and the creation of the 10-year rule that were enacted in the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019.
The inherited IRA rules also are complicated before taking into account the proposed IRS regulations requiring some beneficiaries to take annual required minimum distributions in the first nine years after inheriting traditional IRAs.
Those rules are important, and details about them are in the May and June 2022 issues of Retirement Watch.
There are a host of under-the-radar rules beneficiaries need to know to minimize taxes and penalties and maximize the benefits of inherited IRAs.
Here’s a review of them.
Don’t contribute to an inherited IRA. It seems easier to add money to an inherited IRA instead of dealing with a separate IRA.
But the tax code prohibits contributions to an inherited IRA. Contributing any amount to the inherited IRA results in termination of the entire IRA.
The IRA balance will be treated as distributed to the beneficiary in the year of the contribution and will be taxed as ordinary income.
Don’t convert an inherited traditional IRA to a Roth IRA. It’s simply not allowed.
You can take a distribution from an inherited traditional IRA, pay taxes on it and contribute money to a Roth IRA.
But the contribution is limited to the year’s IRA contribution limit ($8,000 in 2024 for those 50 and older), and you must have earned income for the year of at least the amount you contribute.
The annual contribution limit is after aggregating all contributions made to your IRAs during the year.
IRAs inherited by multiple beneficiaries can be split tax free. Many people name all their children as equal beneficiaries of their IRAs. But the children can have difficulty agreeing on management of the IRAs.
The tax code allows the beneficiaries to divide the inherited IRA tax free into separate IRAs for each of them. Some IRA custodians require this of inherited IRAs, so they don’t have to deal with conflicts among the beneficiaries.
The split can be done whether the beneficiaries are all non-spousal beneficiaries or a combination of a surviving spouse and non-spousal beneficiaries.
To make it easy and to maximize benefits, beneficiaries should make the split by Dec. 31 of the year following the year the original owner died.
Be sure the custodian retitles the inherited IRA correctly. To defer taxes on an inherited IRA, the account must be retitled and the new title must meet several requirements.
The title must include the deceased owner’s name, that he or she is deceased, the date of death, that it is an inherited IRA for the benefit of (or FBO), and then name the beneficiary. Some custodians also include the beneficiary’s Social Security number and that he or she is a beneficiary.
Don’t make the mistake of not changing the account title or changing it to the beneficiary’s name. In the first case, the IRA will have to be distributed in no more than five years. In the second case, the IRS will treat it as being fully distributed when the name is changed.
Most inherited IRAs can be moved to a different custodian. The tax code allows an inherited IRA to be moved tax free from one custodian to another. Many beneficiaries do this so the inherited IRA will be at the same financial services firm as their other assets.
First, confirm that the original IRA is retitled correctly, as discussed earlier. Then, be sure it is transferred to an IRA at the new custodian with the same title.
Finally, have the custodians transfer the money between themselves, especially if you’re a non-spousal beneficiary. Don’t take personal possession of the account, or it will be treated as a distribution.
There are some exceptions. A custodian might prohibit an IRA from being moved to another custodian or charge a fee to move the account. Some IRAs hold proprietary investments that can’t be transferred to another custodian, though it might be possible to liquidate the investment and transfer cash.
The 10% early distribution tax doesn’t apply. The penalty applies to many distributions to IRA owners before age 59½. But distributions made after the death of the original owner aren’t subject to the 10% penalty, no matter how young the IRA beneficiary is. Distributions from a traditional IRA will be included in gross income and taxed as ordinary income.
The five-year rule for Roth IRAs doesn’t apply. Original owners of Roth IRAs might need to wait five years to ensure all distributions are tax free. See our May 2024 issue for details.
But the five-year rule doesn’t apply to inherited Roth IRAs. Distributions to beneficiaries will be tax free regardless of how long the IRA was open or how long the beneficiaries had Roth IRAs.
Investments in the IRA can be changed. This is another move that might be limited by the custodial agreement. But as far as the tax code is concerned, an inherited IRA may be invested in anything an original IRA can own. Investments can be changed as soon as the beneficiary takes title to the IRA.
Beneficiaries should name successor beneficiaries. Suppose you inherit an IRA but pass away before the IRA is fully distributed.
The custodian’s records and policies determine who inherits next. The beneficiary usually has the right to name a successor beneficiary, and the custodian will transfer the IRA to whomever is named.
If a successor beneficiary isn’t named, the custodian’s policies determine who inherits. Usually, the IRA will be inherited by your estate. It could be caught in the probate process, and taxes on its distributions might be higher than if an individual inherited them.
Surviving spouses have special privileges. A surviving spouse who inherits an IRA should know the unique planning opportunities available, such as titling the IRA in his or her own name and being exempt from the 10- year rule. See the June 2022 issue for details.
