The rules governing inherited IRA assets depend upon the beneficiary’s relationship to the original IRA owner and the type of IRA that is inherited.
When the beneficiary of inherited IRA assets is a surviving spouse, the rules are simple—the spouse has the option of rolling the assets over into his or her own IRA within 60 days of taking the distribution from the decedent’s IRA. For income tax purposes, a spousal rollover of IRA benefits is not considered a distribution and therefore has no income tax consequences. On the other hand, when the beneficiary of inherited IRA assets is a non-spouse (i.e., child, grandchild, other relative, friend, etc.), the rules become quite complicated and carry various tax consequences if not followed properly.
Unlike a surviving spouse, a non-spouse beneficiary does not have the option to roll over the IRA benefits into his or her own IRA. Rather, when a non-spouse beneficiary inherits IRA assets, the beneficiary generally has three options from which to choose. Each option carries specialized rules as well as various pros and cons, which should be considered carefully when making a decision regarding distributions:
1. Take an immediate distribution.
A non-spouse beneficiary can choose to have the inherited IRA assets distributed to himself or herself immediately. Once the assets are distributed to the beneficiary, they are treated as the beneficiary’s own, and may be used or invested as the beneficiary chooses. Although taking an immediate distribution allows greater flexibility to the beneficiary, the distribution will be included in the beneficiary’s gross income and subject to ordinary state and federal income taxes. Depending on the value of the IRA assets, the amount of income taxes due on an immediate distribution in full could be significant. Despite the potential income tax consequences, it is important to note that a beneficiary who is under the age of 59½ will not be subject to the 10% penalty for early withdrawal for the distribution of assets. If a beneficiary needs immediate access to the money, taking an immediate distribution of the entire inherited IRA may be most beneficial.
2. Transfer the assets into a non-spouse inherited IRA and take RMDs.
A non-spouse beneficiary has the option of transferring the IRA assets into an inherited IRA, sometimes also known as a beneficiary distribution account. It is important that the beneficiary complete what is known as a “trustee-to-trustee transfer,” where the assets move directly and immediately from the existing IRA account to the new, inherited IRA account. Unlike the spousal IRA rollover, there is no option for a 60-day rollover when a non-spouse beneficiary inherits IRA assets. If the assets are distributed directly to the non-spouse beneficiary, the money will be taxed as ordinary income and cannot later be transferred into an inherited IRA.
An inherited IRA account remains in the name of the decedent, and although a “new” retirement account is created, the beneficiary is not able to make new contributions to the inherited IRA account. Keeping the inherited assets in an IRA account allows the assets to continue to grow on a tax-deferred basis. Thus, if a beneficiary does not have an immediate need for the money, transferring the assets to an inherited IRA may have the greatest long-term growth benefits. Notwithstanding the asset growth advantages, a beneficiary of an inherited IRA is required to withdraw a certain amount of money each year based on his or her age and life expectancy, and also other various factors (including whether there are additional beneficiaries). These required distributions generally begin in the year after the year of death and are more commonly known as “required minimum distributions” (RMDs).
3. Disclaim all or part of the assets.
A non-spouse beneficiary can choose to decline to inherit all or part of the IRA assets by executing a disclaimer. If a disclaimer is executed, the IRA assets will pass to the contingent named beneficiaries or, in the event there are no contingent beneficiaries, pursuant to the IRA provider’s contractual defaults. The decision to disclaim IRA assets is an irrevocable decision by the beneficiary, which must be made within nine months of the original IRA owner’s death and before taking possession of the assets. Before making a decision to disclaim, the beneficiary should consult with tax and estate planning professionals to consider the potential benefits and consequences of such a decision.