You can cash out an inherited individual retirement account (IRA) and use it to fund a major purchase like a house with no tax penalty, thanks to new rules established by the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. The rules pertain to non-spouse beneficiaries of IRAs.
Let’s explore how it works.
- Before the Setting Every Community Up for Retirement Enhancement (SECURE) Act, non-spouse beneficiaries of individual retirement accounts (IRAs) could “stretch” their distributions (and tax benefits) over several generations while the IRA continued growing tax-free.
- The SECURE Act abolished the stretch IRA for most beneficiaries, and now the entire balance of the account must be distributed within 10 years of the original owner’s death.
- There are exceptions for eligible designated beneficiaries, including surviving spouses, minor children of the deceased, beneficiaries less than 10 years younger than the deceased, and beneficiaries who are disabled or chronically ill.
- While non-spouse beneficiaries can cash out an IRA without owing the 10% early withdrawal penalty, doing so could trigger a substantial tax bill.
IRA Required Minimum Distributions: Traditional vs. Roth
If you have a traditional IRA, you have to start taking annual required minimum distributions (RMDs) when you reach age 72 (or 70½ if you reached 70½ before Jan. 1, 2020). The amount that you receive is treated as ordinary income and subject to income tax at your tax bracket rate.
On the other hand, Roth IRAs have no RMDs during the account owner’s lifetime. So, the account can continue growing tax-free for your heirs if you don’t need the money.
The rules work differently for IRAs that you inherit. Before the SECURE Act, most beneficiaries had to take RMDs. But they 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 were, the smaller the RMD. The advantage of this stretch IRA strategy was twofold:
- A smaller distribution and, hence, less of a tax bite
- More money left to grow tax free within the IRA
However, the SECURE Act abolished the stretch IRA for most beneficiaries. Now, inherited IRA balances generally must be depleted within 10 years.
The SECURE Act and Inherited IRAs
Passed at the end of 2019, the SECURE Act changed the game. Here’s a basic rundown of the new rules for inherited IRAs:
- Spousal beneficiaries usually transfer funds to their own IRAs, though they have other options, such as taking a lump-sum distribution.
- A minor child of the deceased, someone less than 10 years younger than the deceased, or someone who is chronically ill or disabled can open an inherited IRA and take distributions over time, take a lump-sum distribution, or disclaim the account.
- A non-spouse beneficiary who doesn’t fall into one of the special categories (e.g., a minor child of the deceased) can open an inherited IRA and take distributions within 10 years, take a lump-sum distribution, or disclaim the account.
Once a minor child reaches the age of majority, the 10-year clock kicks in for distributing IRA assets as a beneficiary.
So, non-spouse 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. (The old rules cover beneficiaries who have already inherited IRAs.)
The stretch IRA is still allowed for surviving spouses and certain non-spousal beneficiaries, including minor children, beneficiaries who are disabled or chronically ill, or those not more than 10 years younger than the original account holder.
The 10-year rule applies whether the participant dies before, on, or after their required beginning date (RBD)—the age at which they had to start RMDs. Still, the SECURE Act doesn’t specify any sort of schedule. You can prorate distributions over the decade or withdraw everything in a lump sum in one year. However, doing so from a traditional IRA could trigger a hefty tax bill and even bump you into a higher tax bracket.
Inherited IRAs and Home Purchases
This brings us around to buying that home. Since you have to take out the funds anyway, doing so to purchase property may not be the worst idea, especially if it means that you can make a bigger down payment or perhaps even buy the place outright.
Bear in mind, you might owe income taxes on the sum that you withdraw—and if it’s considerable, then 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 younger than 59½ and took it out of your own IRA. True, first-time homebuyers are exempt from the 10% penalty—but you can only use $10,000 of your IRA for that.
Of course, you may not have to worry about paying the penalty or taxes if you inherit a Roth IRA, which receives the same tax-advantaged treatment as the original account. As long as the Roth was opened at least five years ago, your withdrawals will be tax- and penalty-free—even if you withdraw everything at once.
What is an eligible designated beneficiary (EDB)?
The Setting Every Community Up for Retirement Enhancement (SECURE) Act prevents most individual retirement account (IRA) beneficiaries from stretching distributions over their lifetimes. However, the law created a group of beneficiaries called eligible designated beneficiaries (EDBs). An EDB is exempt from the 10-year distribution rule and is still allowed to stretch distributions over their life expectancy. You qualify as an EDB if you inherit an IRA from your spouse, are the minor child of the original account owner, are less than 10 years younger than the original account owner, or are disabled or chronically ill.
When do required minimum distributions (RMDs) start?
The SECURE Act upped the age when required minimum distributions (RMDs) start. You have to start taking RMDs when you reach age 72. Before the SECURE Act, the age was 70½, and if you reached that age before Jan. 1, 2020, you had to start taking RMDs then.
How are individual retirement account (IRA) RMDs taxed?
Traditional IRA RMDs are taxed as ordinary income at your tax rate, with a top tax rate of 37% for 2022. Qualified withdrawals from Roth IRAs are not taxed.
The Bottom Line
Depending on your situation, it could make sense to cash out an inherited IRA to fund a large purchase. Still, be sure that you understand the tax consequences before making any decisions, keeping in mind that you will also miss out on up to 10 years of potential tax-free growth in the account. It can be helpful to consult with a financial planner or tax advisor who can explain your options and help you pick the best path forward.