Selecting beneficiaries is one of the key building blocks of estate planning: Without the right name on the right dotted line, assets can wind up in the hands of those the deceased did not intend. All assets need the correct 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, IRA 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 as 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 59½.
  • Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA nor can they contribute to an inherited IRA.

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) (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,” says 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 says. “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.”

One recent huge change is that the SECURE Act, passed as part of two year-end spending bills and signed into law on Dec. 20, 2019, ended the practice of permitting stretch IRAs, in which RMDs could be extended over the lifetime of a non-spousal beneficiary, and could be passed along to a second-generation beneficiary. Under the new legislation, non-spouse beneficiaries have to withdraw all the inherited funds within 10 years of the death of the original account holder.

Non-spouse beneficiaries cannot roll the inherited IRA into their own IRA nor can they contribute to an inherited IRA. 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 59½), 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 72, they must begin taking RMDs within a year of inheriting the IRA.

An individual who inherits IRA assets from the original IRA owner is referred to as the first-generation beneficiary. If the first-generation beneficiary subsequently dies, his or her designated beneficiary is the second-generation beneficiary.

The Bottom Line

Inherited IRAs can still be tools to build and preserve wealth. But with the elimination of the stretch IRA, that wealth cannot continue to build for decades. Check with a financial planner or estate tax expert to make sure of getting the most from an inherited IRA and not creating penalties by not following the proper new procedures. Also, review any estate planning that was predicated on the use of stretch IRAs or other wealth-preserving strategies that may have changed.