When someone dies, assets are distributed to survivors based on a variety of factors. Dividing up assets like homes and bank account balances can become complicated, especially if the deceased person had no will. But if your loved one had retirement accounts like a 401(k) or IRA, distribution usually depends on the person listed as the beneficiary on the plan. The difference between an inherited IRA or beneficiary IRA depends on how it’s set up at the start. However, both terms are used interchangeably, since they essentially refer to the same thing – an IRA that is inherited by a beneficiary after death.
What Is an Inherited IRA?
An inherited IRA is one that is handed over to someone upon your death. The beneficiary must then take over the account. Generally, the beneficiary of an IRA is the deceased person’s spouse, but this isn’t always the case. You can set up your IRA to go to a child, parent or other loved one, although the inherited IRA rules are different for spouses versus non-spouses. You can even set up an IRA to go to an estate, trust or your favorite charity.
If you’re the surviving spouse, you have three choices with your inherited IRA. You can simply designate yourself as the account owner, roll it over into another type of retirement account or treat yourself as the beneficiary rather than making it your own. If you’re a non-spouse inheriting the IRA, you don’t have the option to make it your own. You’ll need to either make a trustee-to-trustee transfer or withdraw it. You’ll likely be required to take the money out within five years of the original account owner’s death.
What Is a Beneficiary IRA?
When someone mentions a beneficiary, he may be referring to an inherited IRA, since the terms are often used interchangeably. However, some refer to a beneficiary IRA as one that is set up specifically with the intent of going to someone upon the account holder's death. There is no beneficiary IRA definition in the IRS tax code, although inherited IRA is defined in two separate areas. Some investment advisers may refer to an inherited IRA as a beneficiary IRA, so it’s important to be specific if your goal is to ensure your IRA goes to someone specific, such as a child. However, in either case, you’ll be asked to specify a beneficiary when you set up your IRA.
The term “beneficiary IRA” may also be used to refer to the account you set up to house your IRA once you’ve inherited it. This is also known as a beneficiary distribution account, and non-spouse beneficiaries are required to set one up. The funds are then “distributed” to this account and take payments from that new account. A spouse has the option of keeping the funds in his name, rolling them into his own account or creating a beneficiary distribution account to take payments as directed.
Taxes on Inherited IRA
Taxes are an important part of the beneficiary IRA definition, but they often go unmentioned. The reason for that is that IRA accounts remain untaxed as long as the money stays in the account. Taxes only become an issue in the tax year you take some or all of the money out. To understand what that means for you, you’ll first need to know the rules that apply to the original owner of an IRA, since they’ll also apply to you.
If the IRA you inherited is of the traditional variety, the money was put into the account before taxes, which means at the time of withdrawal, the IRS is going to want its share. Every dollar you take out will be taxed along with your other income for that tax year. The taxes you pay will be based on your income tax brackets for the year. Roth IRAs, however, were funded with after-tax dollars, so as long as the timing is right when you inherit it, you’ll be able to take money out tax-free. With a Roth IRA, you’ll only pay income taxes if the account was less than five years old at the time of the owner’s death. No matter what type the IRA is, though, you’ll likely be assessed a 10 percent penalty if you take money out before the age of 59½. The difference is that with a Roth IRA, that penalty will only apply to the earnings of the account, not the original funds that were put into it.
The Five-Year Rule
One of the most often emphasized inherited IRA rules is that you must take the funds out within five years. The rule is designed to give you five years to take out the funds, but it also means you’re required to have the money out of the account no later than Dec. 31 of the fifth year after the owner’s death. This rule only applies if you choose to take the option where you withdraw funds, not if you choose to put them in your name or transfer them to another account.
The five-year rule is designed to save you, the beneficiary, a period of time where you can withdraw the funds without tax repercussions. With each year of that five-year period, you’ll have a required minimum distribution, which is based on a sliding scale for each year. The five-year rule applies no matter what age you are when you inherit the account. You’ll still be assessed taxes on inherited IRAs as they apply under the tax laws in the year in which you withdraw the funds.
The Stretch IRA Option
One technique some heirs use to try to minimize taxes on inherited IRA is the “stretch IRA.” This strategy involves stretching the account out over many years to allow the funds to grow tax-deferred. This approach works best when the beneficiary is a younger person, such as a child or grandchild, since a widow may not have the guaranteed life expectancy of a younger person. In that case, the funds wouldn’t have the time necessary to grow.
The stretch IRA is basically a way to shelter funds from taxes and let them remain in the account. However, heirs will still be held to required minimum distributions, so they’ll need to check with a financial adviser on what they need to take out each year. But while they’re enjoying those distributions, they’ll have the comfort of knowing the rest of the money is safe from taxes.
Spouse Takeover Downside
If the spouse decides to merely take over the account, there could be one downside. The beneficiary IRA definition usually focuses heavily on the spouse, who most often takes the IRA over, leaving it as is. If it’s a Roth IRA, the problem with this is that you’ll need to leave the money in the account until you’re at least 59½ years old. Any distributions you take before that could mean paying a 10 percent penalty for early withdrawal.
For that reason, despite the fact that the inherited IRA rules allow spouses to take things over, the simplest option isn’t the best. By rolling the funds into your own IRA, you’ll be able to put your name on it and let it grow until you’re ready to take distributions. It also will let you set up the account the way that works best for you, not merely accept things the way they were set up by your spouse. That means you can name the beneficiary you want to take over the funds when you die, resetting the process.
Video of the Day
- Investopedia: Inherited IRA
- Kingdom Trust: 10 Things to Know About a Beneficiary IRA (or Inherited IRA)
- Commonwealth Financial Advisors: 9 Questions on IRA Transfers and Beneficiary Distribution Accounts
- The Motley Fool: How Much Are Taxes on an IRA Inheritance?
- Investopedia: Five-Year Rule
- Charles Schwab: Inherited IRA Withdrawal Rules
- SmartAsset: What Is a Stretch IRA?
- Bankrate: 8 ways to go wrong with an inherited IRA