Inherited IRA rules and regulations are unforgiving. An inherited IRA mistake reduces the distribution possibilities, resulting in potentially adverse tax consequences. When done correctly, however, an inherited IRA can provide years of additional income with the ability to spread and reduce tax liability over the long term.

The rest of the inherited IRA story

After the last blog post, Have You Inherited an IRA? It’s Time To Compare Your Options, I quickly realized the need to address the inherited IRA rules and regulations. The questions generated, especially the “how to…” and “what about…” varieties, have been outstanding. Please keep ’em coming! Knowing the options available to beneficiaries of an IRA and which one best suits your needs are just part of the story.

What’s the point of spending time and energy analyzing an inherited IRA strategy if you do it incorrectly? Here are 6 inherited IRA rules that could sabotage your strategy:

1. No Beneficiary

If an IRA has no named beneficiary and there is a surviving spouse, the outcome depends on the specific IRA agreement and state laws. Here are the key points:

• The IRA agreement’s default provisions: Many IRA custodians have default rules that may designate the spouse as the beneficiary if no other beneficiary is named.
• State laws: In community property states, a spouse may automatically inherit the IRA or must approve of any other designated beneficiary.
• Probate estate: If the IRA agreement doesn’t specify a default beneficiary, the account may become part of the deceased’s probate estate.

When an IRA Goes to a Non-Person (Like an Estate): Two Key Scenarios

If Someone Passes Away Before They Had to Start Taking Required Distributions:

• The estate must empty the IRA within 5 years.
• You can take out money any time during those 5 years.
• You don’t have to take out specific amounts each year.
• The clock starts the year after the person passes away.
• Special note: Due to COVID relief rules, if this happened between 2016 and 2019, you get an extra year (6 years total).
• This rule also applies to all Roth IRAs since Roth IRAs never require distributions during the owner’s lifetime.

If Someone Passes Away After They Already Started Taking Required Distributions:

• The estate must take yearly distributions based on what would have been the original owner’s life expectancy.
• Think of it like following the original owner’s distribution schedule.
• Here’s how to calculate it:
  • Please find the original owner’s life expectancy factor for the age in the year they passed away.
  • Subtract 1 year from that number each year after.
• For example, if Bill passes away at 80, the estate will use his life expectancy factor of 11.2 years minus 1 year, making the first distribution based on 10.2 years. Each year after that, subtract another year.

2. Don’t Forget the Original Owner’s Required Minimum Distribution (RMD)!

If an IRA owner dies after reaching age 73 but before April 1 of the following year, there is no required minimum distribution for the original owner.

However, if the IRA owner died after the April 1 required beginning date, an RMD is required. Check to see if he or she took their RMD. If they did, no additional RMD is needed. If they didn’t, then you, as the IRA beneficiary, must take that RMD by 12/31 of the year the original account holder died.

The RMD will be taxable income for the IRA beneficiary in the year received. If the beneficiary does not take the RMD, they are subject to a 25% penalty or 10% if they take the amount they were supposed to take within two years.

RMDs and RBDs can be confusing, but not something you want to mess up.

3. Inherited IRA Account Title

Unless you’re a spouse who chooses to Treat It As Your Own, the deceased owner’s name must appear in the inherited IRA title and the beneficiary designation.

If John Doe passes away, leaving his IRA to his daughter Jane Doe, the account should be titled something like, “John Doe (deceased June 2019) Inherited IRA FBO of Jane Doe, Beneficiary.” The deceased owner’s name and the words “inherited IRA” or “beneficiary” must be in there.

4. Contribution Rules

Suppose you’re the spousal beneficiary and Treat It As Your Own. In that case, you can contribute to the IRA (as long as you meet all other qualifications) because, technically, it is no longer an inherited IRA. It’s just a plain old IRA that’s yours.

Also, if you, the spouse, are the sole primary beneficiary of an IRA and contribute to the inherited IRA, including rollover contributions, or you don’t take the required distribution for a year as a beneficiary of the IRA, the IRA will be considered Treated As Your Own.

However, you cannot, under any circumstance, contribute to an inherited IRA if you’re either a non-spouse or spouse if there are multiple beneficiaries of the IRA. If you do so, even by mistake, it voids the inherited IRA. You cannot correct it, so don’t think everything will be okay by taking the money back out. Once deposited, even if it’s only 25 cents, a complete distribution of the entire inherited IRA is required, and if it’s a traditional IRA, the total amount is taxable.

5. Transferring Funds

If you do not transfer the inherited IRA correctly, it will result in a deemed distribution, and the entire amount will be immediately taxable (if it’s a traditional IRA). The IRA must go directly from the deceased owner’s IRA to the correctly-titled inherited IRA through a trustee-to-trustee transfer.

However, a surviving spouse also qualifies for the 60-day rollover, which allows you to have the funds paid directly to you, and then you may deposit them into a new IRA. So, if a spouse is going to move the inherited IRA to their own IRA, they can move it over in this manner.

Non-spouses do not qualify for the 60-day rollover. My advice is to always do a trustee-to-trustee transfer in all instances. There is less chance of a mix-up.

6. Charitable Beneficiary

No income tax is payable when the charity receives the IRA as a beneficiary. That’s the simple part. Potential problems arise when both a charity and an individual are primary beneficiaries. In this case, the charity must be paid its portion by September 30 of the year following the owner’s death. If not, a distribution of the entire balance of the IRA must occur within five years if the beneficiary is a non-spouse. A spouse beneficiary still has the option to

• Treat the inherited IRA as their own by designating themselves as the account owner.
• Roll over the inherited portion into their own existing IRA.
• Maintain the inherited IRA.

If you want to name charities and individuals as the primary beneficiaries of an IRA, make two IRAs – one for the charities and a separate one for the individuals. It allows you to accomplish your philanthropic goals while providing individuals with all the beneficiary options without complications.

Inherited IRA rules – the final word

The first step is to select the appropriate inherited IRA option for your situation and goals. The second step is to ensure you follow the inherited IRA rules and regulations to enjoy the benefits of the first step. This cannot be overstated. Income and tax consequences, not just for you but also for future generations, are on the line.

Do you have any questions about the inherited IRA rules or feedback you’d
like to share? I’d love to hear your thoughts, so please feel free to leave a
comment below so we can continue the discussion.