Losing a friend or family member is tragic. No one looks forward to it, but it happens. And if you get a notification that you have just inherited an IRA – you’ll need to know what your options are.

So what are they?

Rules have changed regarding inherited IRAs. And for some reason, I’ve seen a lot of these lately.

If you inherit an IRA from your spouse, it’s fairly straightforward. If you inherit an IRA from anyone else, it gets complicated. Allow me to explain.

Spouses

Spouses can put the IRA in their own name, or combine it with an existing IRA or employer plan. They most likely don’t need to take distributions from it either, depending on their age and circumstances. A surviving spouse can name their own beneficiaries and continue to let the IRA grow over time.

Non-Spouses

For non-spouses, chances are you will need to empty the IRA within 10 years. In other words, unless you are an eligible designated beneficiary (see below for definition), you will be required to take all money out of the IRA by the end of the 10^th year of death. Here’s more information on the “eligible designated beneficiaries”:

And for most of you reading this, chances are you have already inherited (or may someday inherit) an IRA from someone and be responsible to take action. There is no stipulation of when you take the money out – it can be all at once or spread over a number of years. And in many of these cases, taxes will be due (at your income tax rate) on the money that is withdrawn.

Looking for a cheat sheet of all possible beneficiary scenarios? Click here to see a handy worksheet that outlines things in more detail, courtesy of Ed Slott. 

You may have heard something like “the death of the stretch IRA”. Well, that is what the recent SECURE ACT did, it basically ended the opportunity to s-t-r-e-t-c-h the IRA distributions over your life expectancy.

What’s the big deal of this, you may be wondering? This is probably best illustrated by using an example.

Example

First, let me clarify that the “stretch IRA” is (was) not an actual IRA type at all. It’s the name for the method of transferring an IRA from one person to another.

When you were allowed to use this method (anyone who inherited an IRA before 12-31-2019 still does), a person could stretch the annual distributions over their life expectancy. The longer your life expectancy, the smaller the withdrawal, and the smaller the tax burden. Assets in the IRA can also grow tax-free for a very long period.

Using real numbers, a 30-year-old grandchild who inherited Grandpa Ralph’s $500,000 IRA in 2019 could take small distributions for her expected life span. In this case, that’s about 53 years (using the IRS life expectancy tables). The accumulated distributions could add up to be millions over time depending on the returns of the investments.

This is a huge advantage for the beneficiary! The account can keep growing despite the withdrawals since they’d only be taking out small fractions each year. The account can modestly grow and still outpace the money coming out.

If that same 30-year-old grandchild inherited the account in 2020, the clock starts ticking on the account needing to be emptied by the time she gets to 40. Not as great a deal for her, especially since the larger withdrawals will have much greater tax impacts. And the investments won’t be growing for an extended period of time.

Implications for the Tax Man

For the IRS, it means they are now able to collect tax dollars sooner. Instead of collecting taxes on Grandpa Ralph’s retirement account throughout your lifetime (very possibly 50+ years), they can get their tax dollars within 10 years.

Even with the new 10-year stipulation, you can still manage this as best as possible. There is no requirement to take money out during those ten years, only that you take it out by the end of the tenth year. Some may choose to take out similar distributions each year to smooth out the tax burden. And that may make it easier to plan.

Or one can choose to take out larger amounts in some years, and smaller (or no) amounts in other years. For instance, if a beneficiary is set to retire in 5 years, she may way to take the distributions in years 6-10 when her income may be lower. It’s best to consult with a planner to map out the best scenarios for the specific situation.

Implications for the original IRA owner (while alive)

You might think it’s a no-brainer to give your heirs your IRA when you die. But consider your tax bracket, relative to what your heirs’ brackets are (or will be). The IRA owner may be in a low bracket relative to their heirs. They might want to employ strategies (Roth conversions? Charitable giving?) to help reduce the tax burden to heirs before they die.

Along the same lines, if you give your two kids the account to inherit, each kid might have more issues than the other. For example, one of your kids might be in a higher bracket and be responsible for much more tax than the other sibling in a lower bracket. There may be other ways to tackle this situation to make things fairer.

Implications for the inheritor 

It’s amazing to think about the date of death implications! If you inherited an IRA from your parent who died 12-31-2019, you could stretch distributions from that IRA over your lifetime. You can manage your taxes and have a lot of control. If that same parent died one day later, 1-1-2020, you have to empty the IRA within 10 years!

The numbers indicate that once someone inherits an IRA, they tend to spend most or all of it right away. They use the opportunity to pay down debt or buy something they have been always wanting. This is human nature, I suppose.

But realistically speaking, most people inherit IRAs that are not substantial in size. The average IRA in this country is barely 6 figures, with most inheriting balances of $100,000 or less. Many use the opportunity to quickly put themselves in a better position financially, and don’t bother to do any planning, unfortunately.

One final option is to disclaim, or refuse, to inherit the account. This is rare and may not seem logical, but it sometimes occurs. If a person disclaims an IRA (doesn’t need it or want it for whatever reason), the funds pass on to the next beneficiary.

Bottom Line

At the end of the day, inheriting an IRA puts the person in a tricky 3-way intersection of estate planning, financial planning, and tax planning. A wrong move can result in expensive consequences, and there usually is not an option for a “do-over”. It’s best to navigate the situation with an industry professional for guidance. At least become more educated on the matters before making any decisions.

Brandon