RMDs and IRAs: Identifying Options for Inherited Retirement Accounts
POSTED ON - August 27, 2019
Written By Scott Engstrom, J.D.
When a person inherits an Individual Retirement Account (“IRA”), there is often an initial panic. “I know IRAs have special tax rules – what can I do with this money?” is a common refrain. The purpose of this blog is to provide a quick overview of the rules pertaining to inherited IRAs, particularly with respect to Required Minimum Distributions (RMDs).
From the outset, it is essential to understand that the particular rules that apply to the IRA inheritance depends on how the inheritor is related to original owner of the account. This blog will focus first on the rules that apply to all inheritors. The focus will then shift to special rules for two different groups: (1) inheritors who are the spouse of the IRA owner; and (2) individual non-spouse inheritors. This blog will not address the rules for trusts and other entities that serve as IRA inheritors.
When an individual inherits an IRA, whether they are a spouse or non-spouse inheritor from the original account owner, they must take at least the annual RMD in order to avoid forfeiting 50% of the amount that should have been withdrawn. If the account is a Traditional IRA, the inheritor will have to pay income tax on the RMDs, whereas the RMDs on an inherited Roth IRA as tax-free on the federal level so long as the funds have been in the IRA for five years or longer. There may still be state taxes on an inherited Roth IRA even where the funds have been in the Roth IRA for five or more years.
For non-spouse inheritors of an IRA, there are essentially two choices: (1) withdraw funds at any time so long as the account is entirely emptied by December 31st of the fifth year following the original account owner’s death; or (2) roll the original IRA over into an Inherited IRA using the inheritor’s life expectancy with RMDs beginning the year following the death of the original account owner. Oftentimes, inheritors elect the second option resulting in lower RMD payments. This gets more complicated when there are multiple non-spouse beneficiaries, but typically each beneficiary must create their own Inherited IRA.
Where an inheritor receives an IRA from their deceased spouse, they likewise have two options: (1) roll the original assets into their own IRA and use their own age and life expectancy to determine the time and calculation of RMDs; or (2) transfer the assets to an Inherited IRA where the initial distribution will be dependent on whether the deceased spouse had yet attained the age of 70 ½. Those spouses electing option one who are under the age of 59 ½ and take a distribution from their own IRA will be subject to the 10% early withdrawal penalty, whereas those who elect option two would be able to access the assets immediately without the 10% penalty. The determination of which option to elect depends on the inheritor spouse’s age, the deceased spouse’s age at death, and the inheritor spouse’s financial situation.
The question then becomes, what if someone who inherited an IRA suddenly requires nursing home care? The good news is that regardless of the option that was selected, and regardless of the inheritor’s relationship to the original account owner, the funds can still be protected from the nursing home by use of a Medicaid Compliant Annuity (“MCA”). Whether the IRA is Traditional, Roth, or Inherited, the planning professionals at our office can assist in facilitating a rollover of those funds into an MCA as part of a comprehensive plan to protect assets and obtain Medicaid eligibility to pay for nursing home care. In this way, funds that were intended to be passed on to future generations can be protected for their original purpose rather than being quickly spent on expensive nursing home bills.
Please note that although this blog addresses rules relating to IRAs and RMDs, which necessarily implicate tax concepts, our office does not provide tax advice. We advise you contact a tax professional if you encounter any of the scenarios addressed above.