Beneficiaries are one of the key building blocks of estate planning: Without the right name and on the right dotted line, assets can wind up in hands unintended by the deceased. All assets need the right beneficiary or beneficiaries, usually dictated by a will.

Whether the beneficiary of an individual retirement account (IRA) can name a successor beneficiary (second-generation beneficiary) is determined by the provisions of the IRA plan document. Sometimes that beneficiary is the spouse of the IRA holder, sometimes not.

Sometimes overlooked by the non-spousal recipient of an inherited IRA is the task of naming beneficiaries themselves. In fact, IRAs holders could not bequeath this asset to beneficiaries until as recently as 20 years ago, when the IRS green-lit IRAs to potentially pass through multiple “generations” of holders—all the while growing tax-deferred. 

Naming Beneficiaries

After inheriting an IRA, a beneficiary’s naming of their own beneficiary or beneficiaries is just an important for non-spouses (and spouses) as it was for the original owner of the account. Also as with the original owner of the IRA, beneficiary designations on the IRA form supersede the instructions of a will: Review and if necessary update the new beneficiaries' list annually or at least every few years.

Key Takeaways

  • Beneficiaries pay no early-withdrawal penalty on the distributions, even if the beneficiaries are younger than 59 ½.
  • Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA nor can they contribute to an inherited IRA.
  • Taking smaller RMDs over a longer timespan lessens the tax bite in a given year and “stretches” or “extends” the account’s value.

An inherited IRA must also be renamed to distinguish it as an inherited IRA and to identify the original account holder and the inheriting beneficiary. For example, “(name of original IRA owner) deceased (original owner’s date of death) for the benefit of (name of beneficiary)”. Another example might be, “(name of deceased and date of death) Inherited IRA for benefit of (FBO) of (name of beneficiary).”

Inherited IRAs: Special Rules

The non-spousal beneficiary must start taking required minimum distributions (withdrawals or RMDs) relatively soon. Those who inherit IRAs may be required to take distributions of the entire account balance over possibly as little as five years. “This may cause their total taxable income to increase substantially—and could push them into the highest income tax brackets,” warned Bruce Primeau, CPA and president of Summit Wealth Advocates, Prior Lake, Minnesota.

Sometimes overlooked by the non-spousal recipient of an inherited IRA is the task of naming beneficiaries themselves.

“Under current law, the person inheriting that IRA must begin taking required minimum distributions by Dec. 31 of the year after the year of the original owner’s death,” Primeau said. “One other piece of advice for those inheriting those IRA dollars, assuming that inheritance is substantial: Consider getting a tax projection immediately and, if possible, increase the contribution rate to their 401(k), 403(b) or other retirement plan to the maximum so they can shelter some of those RMD dollars from taxes.”

To stretch an IRA over the lifetime of a non-spousal beneficiary, RMDs must be taken by Dec. 31 each year. Beneficiaries pay no early-withdrawal penalty on the distributions (even if the beneficiaries are younger than 59 years and six months) but they do pay income tax on RMDs from inherited traditional IRAs; RMDs from inherited Roth IRAs are tax-free. If the heir is older than 70 years and six months, they must begin taking RMDs within a year of inheriting the IRA.

Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA nor can they contribute to an inherited IRA. 

‘Stretch’ or ‘Extended’ IRAs

With special rules can come special advantages, though: A non-spouse heir young enough at time of inheritance could, even with RMDs, accumulate enough in the IRA to substantially improve their own retirement nest-egg.

An individual who inherits IRA assets from the original IRA owner is referred to as the first-generation beneficiary. This individual is able to distribute the assets over his or her life expectancy or the remaining life expectancy of the original IRA owner. If the first-generation beneficiary subsequently dies, his or her designated beneficiary is the second-generation beneficiary.

The younger the heir, the smaller the RMD. Taking smaller RMDs over a longer timespan lessens the tax bite in a given year and “stretches” or “extends” the account’s value for longer tax-deferred growth. (When an inherited IRA passes to multiple beneficiaries, the life expectancy of the oldest beneficiary is used to calculate RMDs.)

Beneficiaries can withdraw all the funds by Dec. 31 of the fifth year following the account owner’s death. Each withdrawal will be included in the beneficiary’s annual taxable income for the year of withdrawal. They can also take a full and immediate payout of the amount of the account (and pay the hefty taxes associated with this move) or disclaim the entire IRA.

Disclaiming an inherited IRA is one way to pass assets on to multiple generations when the account’s primary beneficiary is older than the account’s secondary beneficiary. The primary disclaims the account, which passes to the younger secondary beneficiary. The RMDs are therefore reduced, producing an even smaller annual tax bite and preserving the core amount of the account for future growth.

Second-generation beneficiaries take distributions over the life expectancy of first-generation beneficiaries. The latter is determined in the year after the IRA owner died, with 1 subtracted for each year that has passed. 

The Bottom Line

Inherited IRAs—especially those used with the multi-generational tactic of “stretch” or “extended IRA"—can be powerful tools to build and preserve wealth for decades. Though the procedure to get the most out of these accounts eased in recent years, many steps remain that beneficiary owners have to take for the best tax savings. Check with a financial planner or estate tax expert to make sure of getting the most from an inherited IRA.