What the SECURE Act and Recent IRS Regulations Mean for Spouses Who Inherit IRAs

Some of the most important decisions a surviving spouse will make are how to handle inherited IRAs and 401(k)s.

Yet, advice for surviving spouses has been overshadowed by changes made for non-spouse beneficiaries since the enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in late 2019.

The SECURE Act famously eliminated the Stretch IRA and imposed the 10-year rule on most non-spouse beneficiaries. See our March 2020 issue for details. The IRS issued proposed regulations for the SECURE Act in February 2022, which still haven’t been finalized. Read the May 2022 issue’s update for details.

It’s important that the surviving spouse knows the special options and opportunities available to maximize the after-tax value of inherited retirement accounts.

Surviving spouses have more options with inherited IRAs than other beneficiaries. But these options create the potential for pitfalls.

The five-year rule is one option.

The surviving spouse may choose to distribute all the inherited IRA’s assets within five years after the other spouse passed away. The IRA can be distributed on any schedule within those five years. All the distributions will be included in gross income and taxed in the same way they would have been to the original owner.

The five-year rule usually is the least attractive option from a tax standpoint, but it’s one to be considered when there’s a need for cash. Note that the 10% penalty on distributions made before age 59½ doesn’t apply to distributions that follow the death of the original IRA owner. Only income taxes will be due.

Another option is to treat the account the same as one inherited by a nonspouse beneficiary. Under the SECURE Act and IRS regs, most surviving spouses would fully distribute the entire IRA within 10 years after inheriting it.

In addition, under the proposed regulations, if the deceased spouse had reached the beginning age for required minimum distributions (RMDs), the surviving spouse must take annual RMDs during years one through nine. But in 2022 and 2023, the IRS suspended those RMDs since the regulations hadn’t been finalized. There hasn’t been an announcement about the 2024 RMDs.

Surviving spouses younger than 59½ should be hesitant about the second option, for reasons I explain below.

The third option, and one that’s unique for surviving spouses, is known as the spousal rollover, or fresh start, IRA. The surviving spouse can use this option for his or her share of an IRA even when there are other primary beneficiaries.

In the spousal rollover, the surviving spouse rolls over the assets to an IRA that’s in his or her own name instead of one designated as an inherited IRA.

This can be a new IRA set up to receive the inheritance or an existing IRA. The assets also can be moved tax-free to any other qualified retirement plan account of the surviving spouse, such as a 401(k) account.

The rollover can be done by the IRA custodian, or the surviving spouse can take a distribution and deposit that amount into his or her own IRA within 60 days. To avoid errors, I recommend custodian-to-custodian transfers.

Once a spousal IRA is created, it is treated as though it always were the surviving spouse’s IRA. No reference is made to the previous IRA, and it is not considered an inherited IRA. The surviving spouse names new beneficiaries. The RMD schedule is determined solely by the surviving spouse’s age. That’s why it’s called a fresh start IRA. Once executed, a spousal rollover is irrevocable.

A fourth option is very similar to the third option. The surviving spouse simply treats the inherited IRA as his or her own IRA. This has the same effects as the spousal IRA, but this option rarely is used. The spousal rollover avoids any misunderstanding about the surviving spouse’s intentions.

The best choice usually depends on the surviving spouse’s age.

The spousal rollover IRA is not treated as an inherited IRA. The 10% penalty for distributions taken before age 59½ doesn’t apply to inherited IRAs but will apply to a spousal rollover IRA. If the surviving spouse is younger than age 59½ and takes a distribution from a spousal rollover IRA, he or she must pay the 10% early distribution penalty, unless one of the exceptions applies.

If the surviving spouse is less than age 59½ and might need to take distributions before reaching that age, then the non-spouse inherited IRA treatment likely is the best option.

When the surviving spouse is older than 59½, then the spousal rollover usually is preferred because of its flexibility.

There’s no deadline on when a spousal rollover has to be executed and the decision to treat the IRA as a non-spouse inherited IRA can be changed at any time.

Those two rules allow surviving spouses to have a flexible long-term strategy that can be especially beneficial to relatively young survivors.

The surviving spouse first can treat the IRA as a non-spouse inherited IRA, allowing penalty-free distributions up to age 59½.

After reaching age 59½ (or at any other time), a spousal rollover can be executed with the remaining IRA balance.

In some circumstances, this strategy is less attractive after the SECURE Act and the proposed regulations.

Suppose the surviving spouse is substantially younger than the deceased spouse and the deceased spouse had already reached the beginning date for RMDs.

In that case, when the surviving spouse treats the IRA as a non-spouse inherited IRA, under the proposed regulations annual RMDs must be taken in years one through nine and the entire IRA must be distributed by the end of year 10. If there’s still money in the IRA when the surviving spouse passes age 59½, then it can be converted to a spousal IRA.

When the surviving spouse is 49 or younger, the entire IRA would have to be distributed before age 59½. The surviving spouse might want to treat the IRA initially as a non-spouse beneficiary IRA and take distributions for a few years or take one or two lump sum to avoid the 10% penalty. Then, the rest of the IRA could be rolled over to a spousal IRA.

Whether this is an attractive strategy depends on how likely the spouse is to need distributions before age 591⁄2 and how much of the IRA would be needed.

The effects on the next generation of beneficiaries also should be considered.

When the surviving spouse chooses the non-spouse inherited IRA option and passes away while there’s still money in the IRA, then the next generation of beneficiaries must continue the same distribution schedule the surviving spouse had. The IRA must be fully distributed by the end of the 10th year after the surviving spouse inherited it. The beneficiaries also might have to take annual RMDs if the surviving spouse was taking them.

When the spousal rollover was used, then the 10-year rule and other parts of the SECURE Act apply to the beneficiaries.

There’s one other angle to consider. I regularly advise people not to name their estates as IRA beneficiaries or not to fail to name an IRA beneficiary. That’s because the potential for deferral beyond five years is lost when an entity other than a natural person is the beneficiary.

There’s a narrow exception when the surviving spouse is the sole primary beneficiary of the estate and also the sole beneficiary of the IRA proceeds that pass through the estate.

In that case, the surviving spouse still can execute a spousal rollover within 60 days after proceeds are received from the IRA, but the surviving spouse doesn’t have the option of treating the IRA as an inherited IRA. (IRS Private Letter Ruling 201618011)

If you want your spouse to inherit your IRA and have the widest range of options, you should name him or her as the sole primary beneficiary. Then, be sure your spouse will be informed of the options for handling the IRA and how to choose the better option.

These rules apply whether a traditional IRA or Roth IRA is inherited. For inherited 401(k) inheritances, see the next article.