When you are named the beneficiary of an individual retirement account (IRA), and the IRA owner dies, you may think you've received a tax-free inheritance. Well, that's only partially correct. Under current tax law, the receipt of the inheritance is tax-free, but you are still required to take distributions from the account, which may well be taxable. Taxation depends on the type of IRA involved and the relationship of the beneficiary to the deceased.

Key Takeaways

  • Individual retirement account assets are passed to the named beneficiaries, often the person's spouse, upon death.
  • IRA beneficiaries may be required to take required minimum distributions, which can be a taxable event.
  • Non-spousal beneficiaries must withdraw all funds from an inherited IRA within 10 years of the original owner's death.
  • However, spousal IRA beneficiaries have different rules and more options to consider when taking their RMDs.

You Inherit an IRA: What Happens Next?

When you inherit an IRA, you are free to withdraw without penalty as much of the account as you want at any time. However, it's important to be aware of any potential income tax implications for when you withdraw money from an inherited IRA. Also, there are distinct differences in the rules for withdrawing money, depending on whether you're the deceased owner's spouse or you're a non-spousal beneficiary of the IRA.

Traditional IRA

There are various types of IRAs. A traditional IRA offers a tax deduction in the years that the contributions are made to the account. In other words, the contribution amount is used to reduce the person's taxable income in the tax year in which the contribution was made.

You can also make contributions that are not tax-deductible. IRAs also grow tax-deferred, meaning the earnings and interest over the years are not taxed. However, when the money is withdrawn in retirement—called a distribution—the amounts are taxed at the individual's income tax rate in the year of the withdrawal.

If the money is withdrawn before the age of 59½, there's a 10% tax penalty imposed by the IRS and the distribution would be taxed at the owner's income tax rate. If you inherit a traditional IRA to which both deductible and nondeductible contributions were made, part of each distribution is taxable.

Roth IRA

A Roth IRA doesn't offer an upfront tax deduction like traditional IRAs, but withdrawals from a Roth are tax-free in retirement. If you inherit a Roth IRA, it is completely tax-free if the Roth IRA was held for at least five years (starting Jan. 1 of the year in which the first Roth IRA contribution was made).

If you receive distributions from the Roth IRA before the end of the five-year holding period, they are tax-free to the extent that they represent a recovery of the owner's contributions. However, any earnings or interest on the contribution amounts is taxable.

Required Minimum Distributions

The IRS has established a minimum amount that needs to be withdrawn from an IRA each year. These mandatory withdrawals are called required minimum distributions (RMDs). RMDs are designed to eventually exhaust the funds in the account so that the accumulations won't last forever. RMDs apply to traditional IRAs and defined contribution plans, such as 401(k)s. However, Roth IRAs don't require RMDs.

Typically, you must begin your distributions when you reach age 72 (or 70½ if you reach 70½ before January 1, 2020). All RMD withdrawals will be included in your taxable income except for any portion that was taxed before or that can be received tax-free, such as with Roth IRAs. If you fail to take your RMD, you can be subject to a whopping 50% penalty on the amount you should have withdrawn but was not distributed.

The 2020 CARES Act temporarily waives the required minimum distribution (RMD) rules for 401(k) plans and individual retirement accounts (IRAs) and the 10% penalty on early withdrawals up to $100,000 from 401(k)s. Account-holders would be able to repay the distributions over the next three years and be allowed to make extra contributions for this purpose. These measures apply to anyone directly affected by the disease itself or who faces economic hardship as a result of the COVID-19 pandemic.

The SECURE Act and the 10-Year Rule

The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) became law on December 20, 2019. The passage of the Secure Act by the U.S. Congress made major changes to IRA RMD rules.

If a person reached the age of 70½ in 2019, they must have taken their first RMD by April 1, 2020. If a person is due to reach age 70 ½ in 2020 or later, they can take their first RMD by April 1 of the year after they reach the age of 72.

The SECURE Act also changed when money is to be withdrawn from inherited IRAs and defined contribution plans. The SECURE Act requires the entire balance of the participant's inherited IRA account to be distributed or withdrawn within ten years of the death of the original owner. The 10-year rule applies regardless of whether the participant dies before, on, or after, the required beginning date (RBD)—the age at which they had to begin RMDs, which is now age 72.

In other words, you must withdraw the inherited funds within 10 years and pay income taxes on the distributed amounts. If you're under the age of 59½, you won't pay the 10% penalty, but you must pay income taxes on the distributions. However, there are exceptions to the 10-year rule for a surviving spouse, a disabled or chronically ill person, a child who hasn't reached the age of majority, or a person not more than ten years younger than the IRA account owner.

Special Rules for Surviving Spouses

Spouses who inherit an IRA have more flexibility than non-spousal beneficiaries in regards to when they must withdraw the funds. The surviving spouse typically has a few choices. The spouse can treat the IRA as their own IRA by designating themself as the account owner. The spouse can also treat it as their own IRA by rolling it over (or transferring it) into their IRA. They can also treat themselves as the beneficiary rather than treating the IRA as their own.

The choice is usually based on when the spouse is due to take their RMDs or whether the deceased owner was taking their RMDs or not, at the time of their death. The option that's chosen can impact the size of the required minimum distributions from the inherited funds and, as a result, have income tax implications for the spousal beneficiary.

Surviving Spouse Becomes the IRA Owner

If you are the surviving spouse and sole beneficiary of your deceased spouse's IRA, you can elect to be treated as the owner of the IRA and not as the beneficiary. By electing to be treated as the owner, you determine the required minimum distribution as if you were the owner beginning with the year you elect or are considered to be the owner.

Spousal beneficiaries also have the option to roll over the inherited IRA funds, or a portion of the funds, into their existing individual retirement account. Spouses have 60 days from receiving the inherited distribution to roll it over into their own IRA as long as the distribution is not a required minimum distribution. By combining the funds, the spouse doesn't need to take a required minimum distribution until they reach the age of 72.

Becoming the owner of the IRA funds can be a good choice if the deceased spouse was older than the spousal beneficiary because it delays the RMDs. If the IRA was a Roth, and you are the spouse, you can treat it as if it had been your own Roth all along, in which case you won't be subject to RMDs during your lifetime.

However, this is not an all-or-nothing decision. You can parse the account and roll over some of it to your own IRA and leave the balance in the account you inherited., but there's no changing your mind. If you make a rollover and need funds from it before age 59½, you'll be subject to the 10% penalty (unless some penalty exception other than death applies).

Surviving Spouse Is Treated as the Beneficiary

RMDs are based on the life expectancy of the IRA owner. Spousal beneficiaries can plan the RMDs from an inherited IRA to take advantage of delaying the RMDs as long as possible.

If the IRA owner dies before the year in which they reach age 72, distributions to the spousal beneficiary don't need to begin until the year in which the original owner reaches age 72. After which, the surviving spouse's RMDs can be calculated based on their life expectancy. This can be helpful if the surviving spouse is older than the deceased spouse since it delays RMDs from the inherited funds until the deceased spouse would have turned age 72.

If the original owner had already started getting RMDs or reached their required beginning date (RBD)—the age at which they had to begin RMDs, at the time of death, the spouse can continue the distributions as were originally calculated based on the owner's life expectancy.

Please note that the RMD rules for beneficiaries do not eliminate the need for the deceased owner’s estate to take his or her RMD for the year of death if the owner died on or after attaining age 72. The RMD for the owner reduces the account value on which the RMD for the beneficiary is figured.

However, the surviving spouse can also submit a new RMD schedule based on their own life expectancy. This process would mean applying the life expectancy for your age found in the Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B).

Ideally, spousal beneficiaries want to use the longer single life expectancy, so that the annual RMDs are smaller, resulting in a delay in paying taxes on the inherited IRA funds for as long as possible. Remember, you can always withdraw more money than the required minimum distribution, if you need the funds.

When you inherit an IRA, make sure that the title to the account conforms to tax law. If you are a non-spouse beneficiary, do not put the account in your own name. The account title should read: "[Owner’s name], deceased [date of death], IRA FBO [your name], Beneficiary" (FBO means "for the benefit of"). If you put the account in your name, this is treated as a distribution, and all of the funds are immediately reported. It's very difficult to undo this error.

Special IRA Transfer Rule

You can transfer up to $100,000 from an IRA directly to a qualified charity. The transfer, which is called a qualified charitable distribution (QCD) even though no tax deduction is allowed, is tax-free and can include RMDs (i.e., they become non-taxed). In other words, the transfer can satisfy your RMD for the year up to $100,000 and you're not taxed on the amount. This tax break was made permanent by the Consolidated Appropriations Act of 2016, which became law on Dec. 18, 2015.

Handling Tax Issues

When taking RMDs from a traditional IRA, you will have income taxes to report. You'll receive Form 1099-R showing the amount of the distribution. You must then report in on your Form 1040 or 1040A for the year.

If the distribution is sizable, you may need to adjust your wage withholding or pay estimated taxes to account for the tax that you’ll owe on the RMDs. These distributions, which are called nonperiodic distributions, are subject to an automatic 10% withholding unless you opt for no withholding by filing Form W-4P.

If the IRA owner died with a large estate on which federal estate taxes were paid, as the beneficiary you are entitled to a tax deduction for the share of these taxes allocable to the IRA.

The federal income tax deduction for federal estate tax on income with respect to a decedent (such as an IRA) is a miscellaneous itemized deduction. (You can’t claim it if you use the standard deduction instead of itemizing.) Still, it is not subject to the 2%-of-adjusted-gross-income threshold applicable to most other miscellaneous itemized deductions.

However, please check with the custodian or trustee of the IRA for the amount and timing of your RMDs. Also, please consult a knowledgeable tax advisor to ensure that you meet the RMD requirements and the applicable tax laws.