Beneficiary IRA vs. Inherited IRA

When a loved one passes away, the family is faced with the responsibility of managing the deceased’s assets, all while coping with their grief. Among the assets that may be inherited is an individual retirement account (IRA) that is passed on to beneficiaries designated by the original account holder. But, what is an inherited IRA and who are the eligible beneficiaries?

An inherited IRA, also known as a beneficiary IRA, is an IRA account you inherit when the original account holder dies. The beneficiaries are required to move the inherited assets from the original IRA owner’s account to a newly opened IRA in their name. Typically, anyone can inherit an IRA- a spouse, child, brother/sister, parent, other relative, estate, or a trust.

Who can be a beneficiary of an inherited IRA?

Inherited IRA beneficiaries can be grouped into three categories:

Eligible Designated Beneficiary

An eligible designated beneficiary can be the original account holder's spouse, minor children, disabled or chronically ill individuals, and beneficiaries no more than 10 years younger than the original account owner. These beneficiaries enjoy a more favorable treatment when inheriting an IRA than other types of beneficiaries. Eligible designated beneficiaries can stretch the distributions over their lifetime, which can help minimize the tax liability and maximize the benefits of the inherited IRA.

Designated Beneficiary

A designated beneficiary is a non-spouse individual and can be an adult son, daughter, or a qualifying trust named by the IRA owner. These beneficiaries must adhere to the 10-year rule, which requires the entire IRA to be distributed within 10 years of the original owner's death.

Unlike the eligible designated beneficiaries, designated beneficiaries don’t have the option to stretch distributions over their lifetime. However, they still have some flexibility in deciding when and how much to withdraw within the 10-year period, as long as the account is fully distributed by the 10^th anniversary of the account owner’s death.

Non-Designated Beneficiary

A non-designated beneficiary can be an entity such as an estate, charity, or non-qualifying trust that inherits an IRA. These beneficiaries do not have a life expectancy and therefore must follow specific distribution rules.

If the original IRA owner died before their required minimum distributions (RMD) date, the entire IRA must be distributed within five years. However, if the owner had already started taking RMDs, the non-designated beneficiary may be required to continue taking distributions based on the original owner’s remaining life expectancy.

Who is Eligible to Open an Inherited IRA?

An Inherited IRA can only be opened by the person named as a beneficiary on the original IRA holder’s account. Generally, the beneficiary can be a spouse, a non-spouse individual, or an entity.

Spouse

Spousal beneficiaries have the most flexibility with the inherited IRA. They can choose to treat the inherited IRA as their own, allowing them to roll over the retirement money into their existing IRA or to a new IRA. Alternatively, the surviving spouse can open an inherited IRA and take distributions based on their life expectancy.

Non-spouse individuals

Non-spousal beneficiaries such as children, brothers, sisters, or parents of the deceased IRA account owner are also eligible to open an inherited IRA. These beneficiaries cannot treat the inherited IRA as their own and must take distributions within 10 years of the original account owner's death. Failure to distribute the inherited IRA assets within 10 years can result in significant tax penalties.

Entities

Entities like trusts and charities are also eligible to inherit an IRA. If you inherited an IRA through a trust, the structure of the trust will determine how the inheritance is distributed. For example, if the trust is classified as a see-through trust, the inheritance must be distributed to the beneficiary within 10 years after the death of the original IRA owner. If the trust is non-look-through, the distributions must be made within 5 years.

Can an Inherited IRA Be Split Between Beneficiaries?

If there are multiple beneficiaries in an IRA, each beneficiary is entitled to a portion of the account after the original IRA owner’s death. Each beneficiary must open their own inherited IRA account, allowing them to manage their portion of the inherited retirement money independently. Usually, an inherited IRA should include the name of the beneficiary and the name of the deceased IRA account owner.

When splitting an inherited IRA, ensure that the split is completed by December 31 of the year after the original account owner's death. This ensures that beneficiaries can choose their own withdrawal schedules, or use their own life expectancy for Required Minimum Distributions (RMDs).

Distribution options for inherited IRA beneficiaries

Your relationship with the original IRA owner and the age of the original account owner will determine the distribution options you have with the inherited assets. Here are the options you have:

Disclaim the inheritance

A beneficiary can choose not to accept the inheritance. In this case, the inheritance will pass on to other named beneficiaries, or the estate if there are no other designated beneficiaries. You must disclaim the inherited IRA before taking possession of any monies from the deceased IRA account owner, and within nine months after the account owner’s death.

Take a lump sum distribution

A beneficiary can choose to take a lump sum distribution immediately after inheriting the IRA. If you inherited a traditional IRA, you will owe income taxes on the entire distribution at your income tax bracket rate. If you take a lump-sum distribution, it will push you to a higher tax bracket. However, you won’t owe an early withdrawal penalty on the distribution, even if you are below age 59 ½.

Distribute assets within 10 years

The 10-year rule requires that all monies in the inherited IRA must be fully distributed by the end of the 10^th year after the original account owner’s death. This option is available to designated beneficiaries, and a minor child who has attained the age of majority. If you fail to withdraw all the money by the 10^th year, you may be subject to a 50% penalty tax on the remaining distribution.

Transfer funds into your own IRA

A surviving spouse of the deceased IRA owner can roll over the inherited assets into their own IRA so that the money can continue growing tax-deferred. If your spouse had attained RMD age and had not taken the distribution for that year, you must take the undistributed amount from the inherited IRA. Once you transfer the inherited money to your IRA, distributions will be based on your IRA rules.

Stretch distributions over your life expectancy

The stretch distribution option is only available to eligible designated beneficiaries, and it allows these beneficiaries to stretch distributions over their life expectancy. If the original IRA owner was under the RMD age, you will use your life expectancy to determine the distributions. However, if the original IRA owner had reached RMD age, distributions can be spread out over your life expectancy or the remaining life expectancy of the original IRA owner, whichever is longer.