The ability of an inherited IRA to grow on a tax-deferred basis over an extended period is one reason why this kind of account has been used to pass wealth to non-spousal beneficiaries. In 2007, the rules changed, resulting in non-spousal beneficiaries of 401(k) accounts and similar defined contribution retirement plans being able to enjoy the same benefits as the inherited IRAs.
Investopedia’s article, “Inherited IRA and 401(k) Rules Explained,” says spousal beneficiaries of an IRA have the option of taking the account and managing it as if it was their own. This includes the calculation of required minimum distributions (RMDs). For non-spousal beneficiaries, an inherited IRA account can offer them a few options, including the ability to stretch the IRA over time by letting it continue to grow on a tax-deferred basis.
IRA account holders who want to leave their accounts to non-spousal beneficiaries should enlist the help of an estate planning attorney who understands the complex rules surrounding these accounts. The account beneficiaries must be careful to ensure they do not inadvertently trigger a taxable event.
The beneficiaries of an inherited IRA can open an inherited IRA account, taking a distribution (which will be taxable), or disclaiming all or part of the inheritance (causing the funds to pass to other eligible beneficiaries). Traditional IRAs, Roth IRAs, and SEP IRAs can be left to non-spousal beneficiaries in this way. A 2014 rule change says the creditor protection previously afforded to an inherited IRA was ruled void by the U.S. Supreme Court. Inherited IRA accounts cannot be commingled with your other IRA accounts, but the beneficiary can name their own beneficiaries upon their death.
As long as the account holder names a “designated beneficiary”, such as an individual or qualifying trust, then the RMDs for an inherited IRA will be based on the age of the beneficiary using IRS tables in effect for their age at that time. Proper planning can result in income tax deferral for decades.
However, for account holders who die before age 70 ½ – that age at which RMDs must start – and who do not name a designated beneficiary such as an estate, charity, non-qualifying trust or other entity, the inherited IRA must be distributed by the end of the fifth year following the date of the account holder’s death. For account holders who die after age 70 ½ who do not name a designated beneficiary, the inherited IRA must be distributed based upon the age of the deceased holder in the year of their death. As a result, improper planning will lead to in an unnecessary acceleration of income tax liability.
The rules around inherited IRAs and 401(k)s are complex and costly mistakes are made frequently by financial institutions, plan sponsors, beneficiaries and custodians. Be extremely careful when conducting any kind of transactions concerning these accounts, in the naming of beneficiaries, and make sure financial institutions are following the law.
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Reference: Investopedia (December 18, 2017) “Inherited IRA and 401(k) Rules Explained”