The distribution options available to the beneficiary of an IRA are confusing. Traditional vs. Roth. Spouse vs. non-spouse. Is the beneficiary 59½? Was the account owner 70½? Trying to put it all together to determine which inherited IRA option is available and best for your situation is enough to make your head explode. It is, however, essential to get it right. The financial implications and tax consequences could be significant.
We’ve come a long way from when we were expected to work until we would keel over in the fields, factories, or offices, or rely on loved ones for support in old age. Still, retirement is a relatively new thing compared to the history of civilization, thanks to a much-improved life expectancy. Retirement investment accounts are even more recent. Since their creation in the 1970s, the reliance on these accounts has skyrocketed, while the once-popular corporate pension has decreased.
The first long-term retirement plan participants are retired and aging. A transfer of that accumulated wealth has begun. You, my friend, may inherit a portion of that wealth. You have options, but those options also pose risks.
Untangling the inherited IRA
There are three variables to consider regarding your options when you inherit an IRA.
- Spouse vs. non-spouse
- If the deceased owner was over 70½ (or not)
- Traditional IRA vs. Roth IRA
The combination of the variables above dictates how many of the four possible inherited IRA options are available to you. These four options are:
- Treat As Your Own
- Lump Sum
- Life Expectancy Inherited IRA (Stretch IRA)
- 5-year Inherited IRA
- Disclaim the IRA
Treat As Your Own: Only available to a surviving spouse, the spouse can make the IRA their own by either re-titling it in their name or rolling the money, tax-free, into an existing IRA they already have.
Lump Sum: This is self-explanatory. It’s a complete distribution of the IRA. If it’s a traditional IRA, the entire distribution is taxed as income in the year taken. If it’s a Roth IRA, it retains its tax-free distribution status as long as the Roth IRA has been open for 5 years. Otherwise, the earnings are taxable, but the 10% penalty is waived.
5-year Inherited IRA: The beneficiary must withdraw the entire amount of the inherited IRA within five years. You can spread it over five, three, or any combination of years you prefer. It doesn’t matter when, as long as the entire amount is taken out by December 31 of the fifth year after the account owner died.
Life Expectancy Inherited IRA (Stretch IRA): A beneficiary is allowed to “stretch” the inherited IRA based on the life expectancy rules. Your annual distributions are spread over either the deceased owner’s life expectancy or the beneficiary’s single life expectancy, depending on the situation.
Disclaiming the IRA*: A beneficiary is allowed to refuse an IRA. Yes disclaiming is a thing and it just might be in your best interest. When you disclaim an IRA, it then goes to the next beneficiary in line; you don’t get to dictate who gets the IRA. This decision should not be taken lightly. There are rules, repercussions, and traps. Read Thanks, But No Thanks! How To Refuse An Inheritance By Disclaiming to get the low down on how to disclaim an inheritance (IRA or otherwise). If you disclaim it the next beneficiary in line can determine their Inherited IRA options.
Which inherited IRA option is available to you?
Now let’s begin to put all of this together. To make it easier, I created a handy flowchart.
You now understand the options available and when, but that’s only the first step. The second step is determining which one of those options is best for you. That of course, depends on your needs.
Time-Out #1 Inherited IRA Taxability
Traditional Inherited IRA (Lump Sum, 5-year Inherited, Stretch): All distributions are taxable as income, and there is no early distribution penalty, regardless of your age.
Traditional Inherited IRA (Treat As Your Own): If you’re the surviving spouse and Treat As Your Own, the 10% early distribution penalty applies if you’re younger than 59½. (Hint, Hint)
Inherited Roth IRA (all options): You can always withdraw contributions tax-free from an inherited Roth IRA. The withdrawal of earnings are tax-free as long as 5 years have passed since the owner made their first Roth contribution, and the 5-year clock starts on January 1st of the year of the first contribution. Otherwise, earnings withdrawn are taxable. There is no 10% penalty, however, regardless of age. Once the 5-year time limit has expired, all distributions are tax-free. So it isn’t a permanent condition. Also, due to the withdrawal order, earnings come out after contributions.
Show me the money
Whether it’s an inherited Roth or traditional IRA, whether you’re the spouse or not, if you need the funds immediately or in the near future, and aren’t worried about taxes or making the inheritance last, either the Lump Sum or the 5-year Inherited IRA is best. On the other hand, if you don’t need the funds, that’s where the benefits of a Stretch IRA, or if you’re the spouse, the Treat As Your Own IRA, come into play.
For clarity purposes, we’ll first review the spousal options, which are much more complicated than the non-spousal options.
Spousal beneficiary inherited traditional IRA
Which one is appropriate, a Stretch IRA or Treat As Your Own IRA depends on four factors.
- Age of surviving spouse – over/under 59½
- Age of deceased spouse at passing – over/under 70½
- The age difference between spouses, and which one was older
- The need, if any, to withdraw funds
Let’s be honest here. When you have to consider four factors to determine which option is appropriate, it makes things a tad bit complicated.
Surviving Spouse under age 59½
If no withdrawals are needed neither presently, nor until after you’ve reached 59½, then Treat As Your Own. Re-title it under your name or transfer it to an IRA you already have open.
If withdrawals are needed, create a Stretch IRA. Doing so will allow you to take distributions without incurring the 10% early distribution penalty, which you would be subject to if you Treat As Your Own and took distributions.
Had the deceased spouse reached age 70½ at the time of passing?
No, deceased spouse passed away before reaching age 70½
Stretch IRA: Distributions must begin no later than 12/31 of the year the deceased would have reached 70½. The distributions are calculated using the surviving spouse’s Single Life Expectancy Table.
Yes, deceased spouse passed away after reaching age 70½
Stretch IRA: You must begin taking annual distributions no later than 12/31 of the year after the original owner’s death. Distributions are calculated using either the surviving spouse’s life expectancy or the deceased account holder’s remaining life expectancy, whichever is longer based on the Single Life Expectancy Table.
Treat As Your Own: When you make it your own, regardless of whether your spouse reached 70½ or not, distributions are required when you reach 70½, using the Uniform Lifetime Table.
Time-Out #2 Single Life Table vs. Uniform Lifetime Table
Different life expectancy tables, with differing distribution calculations, are used for the Treat As Your Own vs. Stretch IRA. As you’ll see, those differences can have significant repercussions.
The Treat As Your Own Traditional IRA: The Uniform Lifetime Table is used to calculate your distribution (unless you are more than 10 years older than your spouse, then the Joint Life Expectancy Table is used), and is recalculated every year based on your age.
Stretch IRA: The Single Life Expectancy Table is used to calculate your distribution.
Let’s say you and your spouse are both 75 when he passes away in December 2018, and his IRA had a market value of $700,000 at the end of the year (assume he already took his distribution for the year).
If you Treat As Your Own, using the Uniform Lifetime Table, your required distribution for 2019 would be $31,818. The calculation is $700,000/22 (divisor from the Uniform Lifetime table based on your age).
If you created a Stretch IRA, now using the Single Life Expectancy Table, your required minimum distribution (RMD) would be $55,118, or $700,000/12.7 (divisor from the Single Life Expectancy Table).
In this example, as you can see, it pays to make the IRA your own if you don’t need to make withdrawals of more than $31,818. A lower withdrawal means lower taxes and more remains in the IRA.
A surviving spouse should at most times Treat Asr own due to the more beneficial distribution calculation. However, there are always exceptions to that line of thinking.
If a spouse passed away at age 66, but the surviving spouse is 72, they should create a Stretch IRA, because distributions are not required until the late spouse would have turned 70½. At that point, the surviving spouse could then Treat As Your Own to get the more beneficial distribution calculation. I call it the spousal bonus!
Yes, a spouse inheriting an IRA can create a Stretch IRA and then at a future time Treat As Your Own. If the surviving spouse is under 59½ and needs funds, they can establish a Stretch IRA to withdraw funds, avoiding the 10% penalty. Anytime after they reach age 59½, they can Treat As Their Own. That lets them defer any further withdrawals until they reach 70½ if they so choose. On the other hand, they could keep the Stretch IRA and delay distributions until their spouse would have turned 70½, then treat it as their own, like the example above. Please note, you can’t Treat As Your Own and then change your mind and make it a Stretch IRA. A spouse is only allowed to move it from a Stretch IRA to a Treat As Your Own.
A spousal beneficiary traditional IRA is confusing and complicated, especially as it pertains to the ages of the spouses. When to Treat As Your Own own versus when to create a Stretch IRA requires analysis. It’s already a difficult time for the surviving spouse. Figuring out which of the myriad of potential scenarios makes financial sense is challenging.
Spousal beneficiary Roth IRA
Spouse younger than 59½
Similar to an inherited traditional IRA, if no withdrawals are needed presently, or until after you’ve reached 59½, then Treat As Your Own. If withdrawals are required, create a Stretch IRA. Doing so will allow you to take distributions without incurring the 10% early distribution penalty, which you would be subject to if you Treat As Your Own and took distributions. Reminder, don’t forget about the 5-year Roth Rule! Once you reach 59½, use the spousal bonus and Treat As Your Own.
All other scenarios
For everyone else, it rarely pays to create a Stretch Roth IRA as a spouse. The reason? Unlike traditional IRAs, Roth IRAs do not require distributions when the owner reaches age 70½. However, inherited Roth IRAs do. Distributions based on the beneficiary’s Single Life Table are required to begin when the deceased spouse would have attained the age of 70½.
As a spouse, if you’re over 59½, whether you need the funds or not, the best move is to Treat As Your Own to eliminate the potential need to make required withdrawals.
Non-spousal beneficiary options
Thankfully, determining how to proceed with a non-spousal inheritance of an IRA is straightforward compared to the spousal inheritance (refer to Flowchart). That’s due to the fact there is no Treat As Your Own option. That leaves the non-spousal Stretch IRA. Again, my preferred choice.
Non-Spousal Beneficiary Traditional IRA (owner over 70½ at passing)
Stretch IRA: You must begin taking annual distributions no later than 12/31 of the year after the original owner’s death. Distributions are calculated using the Single Life Expectancy Table of either the surviving spouse’s life expectancy or the deceased account holder’s remaining life expectancy, whichever is longer.
Non-Spousal Beneficiary Traditional IRA (owner under 70½ at passing) or Roth IRA (anytime)
Stretch IRA: Distributions must begin no later than 12/31 of the year the deceased would have reached 70½. The distributions are calculated using the beneficiary’s Single Life Expectancy Table.
That’s it. All of the strategizing of which option is best for you, for the most part, pertains to the spousal IRA Inheritance. For the non-spouse, it comes down to 2 questions:
- Do you want to take out all of the proceeds quickly? Use the lump Sum or 5-year Inherited Annuity.
- Do you want to either spread out the tax liability (traditional) or make the inherited IRA last (traditional & Roth)? Create a Stretch.
Inherited IRA – get some help
I couldn’t possibly cover every scenario, but I did want to provide general guidelines of the options available, the decisions to be made, and the results to expect when you’re the beneficiary of either traditional or Roth IRA. Inherited IRAs can have significant financial and tax implications. Please contact your CERTIFIED FINANCIAL PLANNER™ professional to determine what option is in your best interest when you inherit an IRA.
Now you know the options, but the rules are just as important. Continue to expand your inherited IRA knowledge and read The 8 Inherited IRA rules to know before it’s too late.