Inherited individual retirement accounts (IRAs)s have long been a method to allow non-spousal beneficiaries to inherit an IRA account and let the account continue to grow on a tax-deferred basis over time.

In 2007, the rules were changed to allow non-spousal beneficiaries of 401(k) and other defined-contribution retirement plans to treat these accounts in a similar fashion. And on Dec. 20, 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed into law as part of two year-end spending bills, eliminating the rules that had permitted the stretch IRA strategy for sheltering distributions from IRA accounts for any non-spouse who inherits a retirement account from someone who died after Dec. 31, 2019. So what are the rules now?

Inherited IRA Basics

Spousal beneficiaries of an IRA have the option of taking the account and managing it as if it were their own, including the calculation of required minimum distributions (RMDs). For non-spousal beneficiaries, an inherited IRA account used to provide them with several options, including the ability to stretch the IRA over time by letting it continue to grow tax-deferred.

Now, non-spousal beneficiaries have to take distributions from the total account within 10 years of the death of the original account-holder. If that account is a traditional IRA, they owe taxes on each distribution at their current income tax rate. (Receipt of Roth IRA monies does not incur a tax bill, but does remove those funds from further tax-sheltered growth in a Roth account.)

It is important that IRA account holders who want to leave their accounts to non-spousal beneficiaries work with a custodian that understands the complex rules surrounding these accounts. With most major custodians this shouldn’t be an issue. It is also important that the account beneficiaries become aware of their changed options in order to ensure that they minimize the tax impact as much as possible. Working with a knowledgeable financial advisor is a good idea in these situations.

The beneficiaries of an inherited IRA have the option of opening an inherited IRA account, taking a distribution (which will be taxable), or disclaiming all or part of the inheritance, which will cause these funds to pass to other eligible beneficiaries. Traditional IRAs, Roth IRAs, and SEP IRAs can be left to non-spousal beneficiaries in this fashion.

A 2015 rule change says the creditor protection previously afforded an inherited IRA was ruled void by the U.S. Supreme Court. Inherited IRA accounts cannot be commingled with your other IRA accounts, though the beneficiary can name his or her own beneficiaries.

Inherited 401(k) Rules

Prior to the above-mentioned rules change in 2007, the option for non-spousal beneficiaries to put inherited balances from a 401(k) or similar plans, such as a 403(b) and others, into an inherited IRA didn’t exist. The rules were changed to allow these beneficiaries to roll their inherited 401(k) balances directly to an inherited IRA account.

Some plans will allow non-spousal beneficiaries to leave the balance in the plan and take RMDs over the beneficiary’s lifetime (this will likely change because of the SECURE Act's IRA time limits). Or they may permit the beneficiary to leave the money in the plan for up to five years, by which time they must either take distributions or roll the funds into an inherited IRA account.

It is important to note that this rule did not make the ability to do this a mandatory option for retirement plans to offer. The plan sponsor needs to amend its plan document to allow for these distributions. If this is something that you are considering for your heirs, you would be wise to check with your company’s benefits department to confirm that it is an option and how to complete the beneficiary designation form. If it is not offered, you should ask your company to amend the plan accordingly, which is neither costly nor difficult to do.

Required Minimum Distribution

The rules governing RMDs for inherited IRAs or inherited 401(k)s used to hinge upon the age of the original account holder at the time of death. If the account holder had not reached the age at which he or she had to start taking RMDs, then the non-spouse beneficiary had two choices (in addition to cashing out the account immediately, of course). Withdraw the entire amount by the end of the fifth year following the account owner’s year of death or stretch out the account based on their year-end age following the year of death by the owner. The required percentages were based on the Internal Revenue Service table in effect for their age at the time.

If the original account holder had reached age 70½ and was taking RMDs, then the non-spouse beneficiary had to continue taking a distribution each year. Previously, there was the option of creating a stretch IRA in which the RMDs were based upon the non-spouse beneficiary’s age versus the age of the original account holder. This means the distribution amounts could be lower than those of the original account holder (assuming the beneficiary was younger). This allowed the beneficiary to "stretch" the account via tax-deferred growth over time, minimizing the tax impact of the distributions.

Sometimes these benefits could be stretched out over several generations, with first-generation beneficiaries leaving their inherited accounts to second-generation beneficiaries. If the first-generation beneficiary was very young—a grandchild or great-grandchild—the impact could be spread over decades.

Now, under the SECURE Act, these distributions must empty the entire account within 10 years of the death of the original account holder. The Act doesn't explicitly distinguish between IRAs whose account holders were already taking RMDs and those who weren't, so it seems likely that the new 10-year rule applies to both; however, beneficiaries should definitely check with a tax advisor. Some exceptions to the rule exist, too.

Unlike with a traditional IRA account, custodians may or may not provide notification as to the amount of the required distribution. It's incumbent upon beneficiaries to stay on top of this, as the penalties associated with not taking the distribution are stiff.

The SECURE Act's distribute-within-a-decade rule applies only to IRAs whose original owners died after Dec. 31, 2019; IRAs inherited before that are grandfathered in, and the old stretch rules continue to apply.

Creditor Protection

As mentioned above, the Supreme Court ruled that inherited IRA accounts do not offer the same protection from creditors in the event of bankruptcy, a lawsuit, or other situations as do regular IRA, 401(k), and other retirement accounts. If you foresee this as an issue for your heirs, this might not be the route to go with your IRA or 401(k) account.

Other estate planning vehicles, such as a trust, might be in order. Consult your financial advisor or estate planning professional.

Commingling Accounts

As also mentioned above, the non-spouse beneficiaries of inherited IRAs and 401(k)s cannot commingle these account balances with their own IRA or 401(k). Depending upon the circumstances, they may be able to commingle inherited account balances.

If they inherited more than one IRA or 401(k) from the same person, they may be able to combine account balances of the same type. For example, they could combine two inherited traditional IRA accounts into one. Again, this is complex stuff, so make sure that the custodian understands what is being done and that you consult with a qualified financial or tax advisor.

The Bottom Line

Inherited IRAs and 401(k)s can be a great vehicle for passing assets from these accounts to non-spousal beneficiaries, but the rules surrounding them are complex and subject to mistakes by beneficiaries, custodians, and plan sponsors. What's more, the tax rules have significantly changed and previous plans may no longer represent the best course to take.

If you are looking to leave your IRA or 401(k) to non-spousal beneficiaries, make sure that you are dealing with a knowledgeable custodian and that you engage the services of a financial advisor who understands these complex rules in order to avoid costly errors. Mistakes can result in unwanted tax bills for your heirs.