Appreciating Your Spousal Inherited IRA Options

Should you rollover a spousal inherited IRA or just leave it? This is likely just one of the many decisions that has been dropped in your lap. You may also receive much well-meaning advice from friends and family that is not right for you. When a spouse passes away, navigating the complexities of your partner’s financial legacy can be challenging. For spouses who inherit an IRA, understanding the options available is essential to make the most of this inheritance and avoid costly mistakes. This guide breaks down spousal inherited IRAs, focusing on strategies to optimize these accounts.

If you also have a 401(k) to inherit, I discuss those options here.

What Is an Inherited IRA?

An inherited IRA is an account opened when an IRA is passed to a beneficiary after the owner’s death. Spouses who inherit an IRA have unique advantages compared to other beneficiaries. The Secure Act of 2020 (Setting Every Community Up for Retirement Enhancement) and Secure Act 2.0 of 2022 introduced several changes to inherited IRA rules, making it crucial to understand your options.

Key Options for Spousal Inherited IRAs

Spouses can choose from the following options when they inherit an IRA:

1. Lump-Sum Distribution

• If immediate cash is needed, you can withdraw the entire account balance. However, this choice has significant tax implications, as the entire amount becomes taxable income in the year of withdrawal. Lump-sum distributions paid to a beneficiary after the account holder’s death do not carry the 10% early withdrawal penalty, even if the deceased was under age 59 ½. This is because there is a penalty exception when distributions are made due to the account holder’s death.

2. Establish a Spousal Inherited IRA

• Alternatively, you can keep the account in the name of the deceased and withdraw funds as a beneficiary. This option is beneficial if you’re under 59 ½ and may need access to the funds, as distributions won’t incur the 10% early withdrawal penalty.

3. Elect to Be Treated as the Deceased Spouse

• This new option under Secure Act 2.0 allows you to delay required minimum distributions (RMDs) based on the deceased spouse’s timeline and take advantage of favorable distribution rules.

Treat the IRA as Your Own

• By rolling over the inherited IRA into your name, you become the account owner. This approach may allow you to delay RMDs; until you reach age 73 (as of Secure Act 2.0). Contributions can also be made to the account if you have earned income.

Naming New Beneficiaries

When you, as a spouse, inherit an IRA, the naming of new beneficiaries depends on how you choose to handle the inherited IRA. There are three primary options, each with different implications for naming beneficiaries:

1. Treat the IRA as Your Own

• You can roll over the inherited IRA into your own IRA or designate it as your own IRA.
• When treated as your own, you become the account owner and can name new beneficiaries.

2. Remain a Beneficiary of the Inherited IRA or Be Treated as the Deceased Spouse

• You can keep the account as an inherited IRA.
• In this case, you do not own the account but can generally name new beneficiaries for the inherited IRA. The specifics may vary based on the custodian’s (Charles Schwab, Fidelity, etc.) policies, so it’s important to confirm with the financial institution.

Tax Considerations for Inherited Accounts

Understanding the tax implications of inherited monies is critical. As you may inherit some of each, here’s a general summary:

· Traditional IRA distributions are taxed as ordinary income at your tax year’s marginal tax rates

· Roth IRA distributions are generally tax-free, provided the account has been held for at least five years.

· Any taxable asset accounts, such as brokerage and savings accounts you inherit are taxed under capital gains rules.

It’s wise to know at what Federal marginal income tax rate any withdrawals will be made it, as well as what state taxes may also be triggered.

Common Spousal Inherited IRA Pitfalls to Avoid

Misunderstanding the Options

• Spousal beneficiaries often have the broadest options but may lose flexibility if they act hastily. Carefully consider which path aligns best with your financial goals.

Neglecting Beneficiary Updates

• Ensure the IRA has updated beneficiaries to avoid unintended distributions, especially after major life events like divorce or remarriage.

Failing to Take RMDs

• If you don’t take the required RMDs, a hefty 25% penalty applies. While this could be reduced to 10% if corrected promptly, your time is worth more.

Considerations for inherited IRAs where RMDs have started

Yes, a spouse who inherits an IRA where required minimum distributions (RMDs) have already begun has the option to transfer it to your own IRA and base the RMDs on your age. Here’s how it works:

Spousal Transfer (Treat as Own)

• As a spouse beneficiary you can transfer the inherited IRA into your own IRA or treat the inherited IRA as your own.
• Once the transfer is complete, RMDs will be based on your age, not the deceased spouse’s age.

RMDs Before the Transfer

• If the deceased spouse was required to take an RMD in the year of death but didn’t complete it, the beneficiary (you as the spouse) must take that year’s RMD based on the deceased spouse’s schedule before transferring the account.
• After this, future RMDs will be recalculated based on your life expectancy.

Effect on RMDs

• If you are younger than the deceased IRA owner, transferring the IRA may reduce the annual RMDs because they will be calculated using the younger age.
• If you are older, the RMDs may increase after the transfer.

Steps to Transfer

• Contact the custodian holding the inherited IRA and request a spousal rollover or re-registration into your own IRA.
• Confirm that any outstanding RMDs for the year of death are taken first to avoid penalties.
• After the transfer, you will calculate RMDs using the IRS Uniform Lifetime Table for your age.

Considerations for inherited IRAs where RMDs have not started

If you inherit an IRA and the deceased IRA owner had not yet started required minimum distributions (RMDs), you have several options for handling the inherited IRA. Each choice comes with its own rules and benefits:

1. Treat the IRA as Your Own

• You can transfer the inherited IRA into your own IRA or designate the inherited IRA as your own.
• Who it’s best for: If you are younger than the deceased and want to delay RMDs until your own required beginning date (April 1 of the year after they turn 73, or 72 if they were born before 1951).

Benefits:

• RMDs are based on the deceased spouse’s age and life expectancy, potentially reducing the amount of annual distributions.
• Contributions can be made to the IRA if you are eligible (have earned income).

Key Point: This option essentially resets the IRA under your name as if you were the original owner.

2. Inherit the IRA as a Beneficiary (Inherited IRA)

• You can leave the account as an inherited IRA, maintaining it in the name of the deceased owner but designating themselves as the beneficiary.
• Who it’s best for: If you are under age 59½ and may need to access funds. Distributions from an inherited IRA avoid the 10% early withdrawal penalty, even if you are under 59½.

RMD Timing:

• RMDs must start by December 31 of the year the deceased would have turned 73 (or 72 if born before 1951).
• Distributions are calculated using the Single Life Expectancy Table.

3. Rollover to Your Roth IRA

• If you inherit a Traditional IRA, you cannot directly convert it to a Roth IRA as an inherited account. Even if the deceased spouse had a Roth IRA, the traditional IRA cannot be Roth converted into it.
• As the inheriting spouse, you can roll over the inherited traditional IRA into your own Roth IRA, converting it to Roth status. Those monies will benefit from the start date of your existing Roth IRA with regards to satisfying the “five year holding rule”.

Key Point: A rollover to a Roth IRA triggers a taxable event, so this option is ideal when you expect to be in a lower tax bracket in the year of conversion.

Planning Ahead

A spousal inherited IRA can be a significant financial opportunity, but it requires discerning informed decisions. Taxes and unintended withdrawal penalties can quickly dwindle what was intended for you to live on. If you opt for a lump-sum distribution, the added income could push you into a higher tax bracket, significantly increasing your tax liability. Consulting designated professionals such as a Certified Financial Planner, Certified Public Account and Enrolled Agents to plan distributions strategically is recommended.

Whether you’re planning for retirement, covering immediate expenses, or leaving a legacy, understanding your options is key.

Helpful Resources:

1. IRS Guidance on Required Minimum Distributions
2. Secure Act 2.0 Overview
3. Inherited IRAs: Rules for Beneficiaries
4. IRA Beneficiary Planning