Inheriting Traditional IRAs – And the Complexities They Carry

Inheriting a traditional IRA from a parent or relative is a wonderful gift.   What many people do not realize, however, is just how complicated the laws are for those who inherit the IRA.  The rules about what you may do with the account – such as distribute it all immediately and pay the taxes – are seemingly easy but not necessarily tax advantageous. More complex are the rules about what you must do with the account.  

Please note – the following does not apply to spousal inheritances, or Roth IRAs, as they have requirements of their own.  

Let’s begin with a few comments on why there are any requirements at all.  The tax law addressed the growing concerns about retirement readiness in the U.S. by enhancing (via a tax deferral)  a taxpayer’s saving for retirement. The person who established the traditional IRA did so with pre-taxed earnings, and those earnings were allowed to grow tax-free.  The tax benefits, however, are meant to be recouped by taxing the distributions from the IRA starting when the owner reaches retirement age.  A Required Minimum Distribution (or RMD) must be paid from the IRA each year once the owner reaches the designated retirement age, with the exact amount varying by age.  

So what happens when the owner passes away before depleting the IRA?  The beneficiary of the IRA receives the proceeds and can establish an Inherited IRA, with its own rules for minimum distribution and requiring recognition of ordinary income for taxes.  This is when things get especially complicated, because the laws have changed over time with transition periods extending into 2033. For starters, much depends on the age of the deceased and the year of death.

Some of the concepts you should be alert to are:

1. The amount of the RMD is a function of a) relationship to the decedent, b) the birthdate of the decedent, c) the date of death, d) the potential status as a minor child of the decedent and e) the status as a chronically ill or disabled non-spouse.   The SECURE Act effective in 2020 introduced a calculation which generally requires full distribution of the account within 10 years , but the amount required  in each year depends on the above factors.  Then again, the general rule may not apply.  In fact, there are circumstances where the distributions must be made within 5 years.

2. Generally, the Inherited IRA is not allowed to continue tax-free deferral until your retirement age. If you inherit an IRA and you are 40 years old, for example, you are required to take RMDs (and pay the related taxes) despite the fact that you are not near your own retirement date. Once again, exceptions apply under certain circumstances.

3. Significant IRS penalties and interest apply for non-compliance with the requirements for distribution.

Bottom line – this is a particularly complex part of the law with numerous exceptions to the general rules.  You should consult with a knowledgeable tax or retirement professional who can take you through the options and consequences of your personal situation.  To learn more read IRA Publication 590-B, Distributions from Individual Retirement Arrangements, or the article Beneficiary IRAs: A guide to the RMD maze from The Journal of Accountancy.

Inheriting an IRA is, indeed, a wonderful gift. Best to enjoy the full benefits, including continued deferral of taxes for some period, after understanding your options.

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