IRAs are powerful savings tools which have favorable tax benefits while an account owner is alive. When the account owner dies and the assets pass to beneficiaries, the IRS has specific guidelines applying to distribution of these assets. If the timing rules for taking distributions from the IRA are not met a beneficiary can face a penalty of 50% on the amount of the distribution that should have been taken. Understanding how these rules apply to your specific situation can save you from incurring steep penalties and/or taxes.
Rules for Surviving Spouse Beneficiaries
When inheriting IRA assets, surviving spouses are offered the most flexibility. They have the option to treat the account as their own or they can choose to remain a beneficiary and take the account as their own at a future date. Once the spouse takes an Inherited Traditional IRA as their own, the required minimum distribution rules apply when they reach age 70 ½. If the Inherited IRA is a Roth and the surviving spouse takes the account as their own, they are not subject to required minimum distributions.
Rules for Non-Spouse Beneficiaries
The rules for inheriting IRA assets for non-spouse beneficiaries are quite different. Non-spouse beneficiaries are allowed to stretch the distribution of IRA assets over their own lifetimes, but only if they carefully follow the established rules. Non-spouse beneficiaries do not have the option of combining the Inherited IRA assets with existing IRAs in their name. Required minimum distributions from Inherited Traditional IRAs are subject to income tax whereas required minimum distributions from Inherited Roth IRAs are tax-free as long as the 5-year holding rule applicable to Roth IRAs has been met. Early withdrawal penalties do not apply to distributions from Inherited IRAs.
Selecting a Payment Method
Even though the IRS requires the beneficiary to take a minimum distribution from the Inherited IRA at specific times there are several options for scheduling these payments.
Lump Sum Option – Beneficiaries have the option of taking the Inherited IRA assets in a lump sum. However, unless the inherited assets are coming from a Roth IRA, the beneficiary will be responsible for paying tax on the entire distribution based on their current tax rate.
The Five-Year Method – This distribution option is only available to the beneficiary of an Inherited Traditional IRA if the account owner died prior to reaching their required beginning date, which is currently age 70 1/2. Beneficiaries of Inherited Roth IRAs are always allowed this payout option regardless of the account owner’s age at death. The five-year method allows the beneficiary to withdraw any amount from the IRA during this period as long as the entire IRA is distributed by the end of the fifth year following the owner’s death.
Life Expectancy Method – This method allows the beneficiary to stretch out the account by taking minimum annual payments from the Inherited IRA based on IRS guidelines. With the Life Expectancy Method, the beneficiary can benefit from future years of growth while mitigating the tax bill produced by taking the money out all at once.
The Secure Act and Potential Changes to Inherited IRA Distributions
The House recently passed a landmark retirement law which could affect workers, retirees and beneficiaries. The potential impact to non-spouse IRA beneficiaries includes a loss of the existing Stretch IRA Rule, which allows a beneficiary to stretch out the required minimum distributions from Inherited IRAs over the non-spouse beneficiary’s life expectancy. The legislation, if it becomes law, would require that Inherited IRA assets are withdrawn within 10 years. This could result in significantly larger IRA withdrawals for beneficiaries and in turn larger tax liabilities. Roth IRAs could become more attractive if the loss of the stretch goes away because the minimum distributions required of Inherited Roth IRA beneficiaries are tax free. The Secure Act legislation offers exceptions to the 10-year rule — Beneficiaries who are surviving spouses, minors, disabled or chronically ill would be exempt from this rule and are considered “eligible designated beneficiaries” if they meet the qualification criteria. The Senate has similar legislation under consideration known as the Retirement Enhancement and Savings Act. These two pieces of legislation will require reconciliation prior to going to the President.
Distributions from IRAs can be very complex and the penalties for mistakes are high. It is important to work with a team of financial professionals to help you navigate required minimum distributions and how they might affect your goals.Please contact Albion Financial Group to discuss your specific situation and the strategies to consider when determining your distribution options.
Debbie Knotts, CFP®, CLU®
Senior Wealth Advisor and Vice President
Albion Financial Group