Beneficiary Choices With Inherited IRAsby
As spousal beneficiary of an inherited IRA, your clients are entitled to transfer an existing IRA into their name and defer distributions until they are required to begin taking minimum distributions. If they would like to take distributions before attaining the age of 59 ½, a surviving spouse is permitted to open an inherited IRA account.
The complications over beneficiary choices with inherited IRAs tend to focus on non-spousal beneficiaries and the special provisions pertaining to them.
As beneficiary after the death of the original owner of the IRA, one important consideration is that you do not make contributions to the account. The funds continue to be tax-deferred and access tends to be soon following the owner’s death.
As a non-spousal beneficiary, you are not entitled to just roll the inherited account into your personal IRA account (See also the discussion of minimum distribution rules in IR-2021-57, 3/16/21).
There arose a new set of rules with the SECURE Act. We presume a relatively recent inheritance subject to these new rules that apply January 1, 2020, or thereafter.
We also presume the beneficiary isn’t an estate or trust. The rights of the beneficiary of an estate or trust would depend on the terms of the documents, and possibly the discretionary decisions of the executor or trustee (In these circumstances, see also “Can a Trust Transfer an IRA to a Trust Beneficiary?”, Natalie Choate, 3/9/21, Morningstar.com; “SECURE’s Changes to Retirement Plan Distribution Rules, Applicable to Participants and Beneficiaries,” Natalie Choate, 1/9/20, Heckerling SECURE; ataxplan.com).
The individual beneficiary’s options include renouncing all or part the inheritance. It isn’t generally possible to gift an IRA without first being taxed on it. There is a narrow exception for those over 70½ which can allow them to exclude the distribution from income when they name a charity to receive up to $100,000 (See also IRS Pub. 590-B, Distributions from Individual Retirement Arrangements (IRAs)), for use in preparing 2020 returns. The IRS declines to expand 1099-R reporting to include qualified charitable distributions (See IRS Info. Letter 2021-0007).
Another option is taking down the entire inheritance as soon as possible, which is rarely the most tax-wise route because large distributions usually trigger higher tax rates. Special beneficial options apply to the following: the surviving spouse, minor child of the deceased, an individual less than 10 years younger than the deceased (such as brother, sister), or an individual who is disabled or chronically ill.
As to the spouse, an option would be to transfer to his or her own IRA. The funds could be accessed at the surviving spouse’s discretion, albeit penalties may apply if distributions are before age 59 ½.
After 72, the account is subject to required minimum distribution rules based on life expectancy. There is generally a level of creditor protection by having the assets in an IRA. There may be federal and state taxes as distributions are made after the age of 59 ½.
The surviving spouse and others in the groupings mentioned just above (such as brother/sister less than 10 years younger than the deceased) could also open an inherited IRA account. In these circumstances, the general rule is that the beneficiary’s life expectancy determines any required minimum distributions.
If you are a minor, then upon attaining majority under the rules of your home state, you become subject to the new 10-year distribution rule we’re about to discuss. The most common rule for attaining majority is age 18.
There may be some possibility the proposed regulations will have an age rule without relying on the state’s definition of minority. The new 10-year rule reaches those we have not discussed just above (Section 401(a)(9)(H)(i)(1)).
The beneficiary isn’t the deceased’s spouse or minor child, isn’t chronically ill or disabled, or is more than 10 years younger than the deceased. This group could take a lump-sum distribution, which is generally inadvisable due to bunching income in a progressive rate structure.
But in general, the group named in the preceding paragraph is under the new 10-year rule. We believe there is discretion as to when the distributions are taken within the ten years. One can even find literature expressing concern that the proposed regulations may impose a ratable distribution rule but such an IRS posture seems unlikely.
This group could also renounce the inheritance, which might be considered depending on who then inherits and that person’s tax bracket compared to the named beneficiary’s bracket. Gift and estate taxes can also be a consideration.
There is a 50 percent penalty if the entire account isn’t fully distributed at the end of the 10-year period. There is statutory provision to waive the 50 percent penalty in some cases (Sec. 4974(c’)(5) and (d)).
Within the ten year period, we believe there is complete discretion as to the measure of taking down the account. In planning distributions during the 10 years, consider such factors as prospects of the Biden administration enacting higher tax brackets and the possible tax-bracket advantages of spreading income over a period of years.
There’s an advantage generally to deferring taxation. Also consider whether the recipient’s future tax brackets may go down with retirement.
There is no 60-day rollover with a non-spouse inheriting an IRA. Any assets transferred should be from one account to another or from one IRA custodian to another.
Note also that the IRA isn’t necessarily 100% taxable. The decedent may have had some basis in the IRA. Basis may arise because the IRA donor made some contributions during the year, but year-end circumstances wouldn’t permit deductibility. See generally the decedent’s history of Filing IRS Form 8606. The purpose of this form is to keep track of nondeductible contributions.
Following is a summary from the IRS, under the heading “Inherited From Someone Other than Spouse,” Contributions to Individual Retirement Arrangements,” For use in preparing 2020 returns, p. 20:
“If you inherit a traditional IRA from anyone other than your deceased spouse, you can’t treat the inherited IRA as your own. This means that you can’t make any contributions to the IRA. It also means you can’t roll over any amounts into or out of the inherited IRA. However, you can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary (See Pub. 590-B for more information).
Like the original owner, you generally won’t owe tax on the assets in the IRA until you receive distributions from it. You must begin receiving distributions from the IRA under the rules for distributions that apply to beneficiaries.”
As we write in mid-2021, the IRS has yet to issue proposed regulations under these rules. Among the questions to be resolved by such regulations is whether the 10-year period will terminate at the date of death or December 31st of the tenth year.A nother question sometimes raised is whether the state’s law governing the definition of a minor will prevail or whether the proposed regulations will provide a uniform rule for all states.
Our topic is a very important one affecting many taxpayers, and we hope the IRS will soon issue the much-anticipated proposed regulations.
Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...