Rules and Tax Ramifications for a Non-Spouse Inherited IRA Beneficiary
The regulations surrounding the inherited IRA for non-spouses can be tricky, especially with the new rules that were implemented as of January 1, 2020. If you are reading this and you inherited an IRA before this date, the old rules apply. For today’s article, we will talk about the new rules and how they impact you if you are a non-spouse inherited IRA beneficiary. If you are inheriting from a SPOUSE, click here. Let’s get started.
The 10-Year Rule
Perhaps the biggest change to the rules regarding the inherited IRA for non-spouses is the 10-year rule. This rule states that if you inherited an IRA from your parents, an aunt, a grandparent, or anyone who was not your spouse, you have 10 years to distribute the entire IRA. This applies to Traditional and Roth IRAs. This is a major change because the old rules allowed you to stretch those distributions either over a five-year period or for the rest of your life. Now, you don’t have that flexibility; the money must be fully distributed in 10 years.
Why This Change in Non-Spouse Inherited IRA Rules Matters
The reason that this is significant boils down to taxes. Anything that you take out of an IRA (except for Roths) is taxed as ordinary income. For example, in the past, if you inherited a $250,000 IRA, you could continue letting that account grow and take small distributions from the account – maybe only a few thousand dollars depending on your age – to stay compliant with the stretch RMD provision. Now you have 10 years to distribute the whole thing. You have several options:
- Take it all at once
- Take it evenly over 10 years
- Take more in one year versus the other
The bottom line is that the full amount must be distributed out of the account after 10 years.
Keep in mind that, if you inherited an IRA from someone who was taking out RMDs, you would need to take out RMDs during those 10 years, too. For example, if an IRA owner died July 15th, 2020, after starting RMDs, the beneficiary of the non-spouse inherited IRA is required to take out RMDs starting in 2021 and each year thereafter. By December 31, 2031, all remaining assets in the IRA must be distributed. So, you need to factor in at least taking your RMD in your distribution plans during that 10-year span.
Are There Other Exceptions to These Non-Spouse Inherited IRA Rules?
It’s important to know that there are, indeed, several exceptions to the 10-year rule. Here are the four key exceptions to know:
- If you inherited the IRA from your Spouse
- If you are chronically ill or disabled
- If you are a minor
- If you are 10 years or less younger than the former owner of the IRA
Here are examples of each of these exceptions in action:
Non-Spouse Inherited IRA Spousal Exception
Luis’ wife Christina passed away. She had an IRA and Luis is the beneficiary of the account. Luis, because he was the spouse, has different rules that he can follow for distributions.
Non-Spouse Inherited IRA Disabled or Chronically Ill Exception
Veronica passes away at 61. Her son, David, who is 32 years old and has a disability, is the beneficiary of her IRA. He can opt to take distributions over the course of his life expectancy instead of adhering to the 10-year rule.
Non-Spouse Inherited IRA Minor Exception
Terrance passes away unexpectedly at age 40. Terrance’s son, Drew, was the primary beneficiary of his IRA. Because Drew is 11 years old, he can take distributions over his life expectancy instead of adhering to the 10-year rule.
Non-Spouse Inherited IRA 10 Years or Less Younger Exception
Carrie is 43 and Jenna is 39. They are siblings. Carrie passes away suddenly, and Jenna is the primary beneficiary. Jenna can opt to take distributions over her life expectancy instead of adhering to the 10-year rule.
Your Next Steps Are Crucial
With the 10-year rule now being the standard for most non-spouse inherited IRA beneficiaries, a lot more strategy is involved. You have between when you inherit it and December 31st of the year of the 10th anniversary of the owner’s death. Between now and then, you need to come up with a plan – and there should be more thought to it than simply dividing it by 10 or taking it all out at once. The reason is that your financial circumstances may call for bigger or smaller distributions in certain years versus others.
- Maybe you have children who will be going to college and, because financial aid looks at the last two years of family income, elevated income from IRA distributions may disqualify them from any aid.
- Perhaps you have income reduction or credits that can be used in certain years that allow for accelerated distributions in those years.
- If you are in between jobs, you might use more of the Inherited IRA to supplement income since your W2 income will be lower.
The possibilities are endless, which is why part of our comprehensive planning process at MDRN Wealth includes identifying where these opportunities are and helping you come up with a game plan. This can be the difference in thousands of dollars in taxes, so it is important that you prioritize it.
If you have more questions about coming up with a plan for your non-spouse inherited IRA, please reach out or schedule a call with us to discuss your personal circumstances. We specialize in the complexities and nuances of inherited IRAs and are happy to help.
MDRN Wealth LLC does not provide specific legal or tax advice. Please consult with professionals in these areas for specific legal and tax recommendations. The information provided herein is general information. It is not intended to be construed as investment, tax, or legal advice. Information in this article is not an offer or solicitation to purchase, sell, or endorse a specific company, security, investment vehicle or strategy. Investing involves risk and the possible chance for loss of principal. Please consider your tolerance for risk before investing. Past performance is never guaranteed and future results can vary. Opinions conveyed by MDRN Wealth LLC cannot be viewed as an indicator of future performance and are subject to change. Results may vary. Use information at your own risk.