Cashing out an inherited IRA and using it to make a major purchase, like a home, without tax penalties is possible thanks to the new rules established by the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 for non-spousal beneficiaries of individual retirement accounts (and other retirement plans too). Let's explore why.
- Non-spouses who inherit IRAs have to take distributions from the account.
- A non-spousal beneficiary can use inherited IRA funds to buy a home (or anything else) without penalty, whatever their age.
- The SECURE Act arguably made it more advantageous to make such major purchases, since it mandates that most non-spousal beneficiaries must deplete inherited IRAs with 10 years.
The Rules of Inherited IRAs
Inherited IRAs work somewhat differently than ones you establish yourself. If you are bequeathed an individual retirement account (IRA) by someone other than a spouse—a parent, another relative, or even a friend—you have to start taking annual required minimum distributions (RMDs) from it, even if you haven't retired and are far from the usual age at which RMDs kick in (which the SECURE Act increased from 70½ to 72, by the way—effective as of Jan. 1, 2020). The amounts you receive will be treated as ordinary income (for you) and are, therefore, subject to income tax (at your tax-bracket rate).
If you fail to withdraw at least the required minimum amount each year, you could owe the Internal Revenue Service (IRS) 50% of what the distribution should have been.
Obviously, this could be onerous, especially if the deceased account holder had a large balance and was advanced in years: RMDs are based on the size of the IRA and the IRA owner's life expectancy, increasing as he or she ages (to be blunt, the IRS wants to ensure it gets its due before the owner dies). The good news was that beneficiaries could reset the RMD clock, so to speak, by using their own ages (presumably much lower than the deceased's) and life expectancies to calculate the size of the required distribution. The younger you are, the lower the RMD.
The advantage of this "stretch IRA" strategy was twofold: a smaller distribution (and, hence, less of a tax bite), and more money left to grow tax-free within the IRA.
The SECURE Act's Impact on Inherited IRAs
Passed at the end of 2019, the SECURE Act changed the game. Now, non-spousal beneficiaries who inherit IRAs after Dec. 31, 2019, have to withdraw all funds from it by the end of the 10th calendar year after the original account holder's death—no more basing distributions on their life expectancies. (Beneficiaries who have already inherited IRAs are grandfathered into the old rules.)
The stretch IRA is still allowed for surviving spouses, and certain types of non-spousal beneficiaries, such as minor children, disabled individuals, or those not more than 10 years younger than the original account holder.
The SECURE Act doesn't specify any sort of schedule, though: You could pro-rate distributions over the decade, or withdraw everything in a lump sum in one year.
At least for 2020, RMDs aren't a consideration. That's because required minimum distributions for traditional IRAs and 401(k)s were suspended in 2020 due to the March 2020 passage of the CARES Act, a $2 trillion stimulus enacted amid the economic fallout from the COVID-19 pandemic.
Inherited IRAs and Home Purchases
This brings us around to buying that home. Since you have to take the funds out anyway, doing so to purchase property isn't the worst idea in the world—especially if it means you can make a bigger down payment or perhaps even buy the place outright.
Bear in mind, you will owe income taxes on the sum you withdraw, and if it's a considerable one, it could knock you into a higher tax bracket. However, the amount that you receive as a distribution will never be subject to any early-withdrawal penalties, as it would be if you were under 59½ and took it out of your own IRA. True, first-time homebuyers are exempt from that 10% penalty—but the amount they can withdraw is limited to $10,000.