Inherited IRA Rules & SECURE Act 2.0 Changes

One way wealth passes from generation to generation is through retirement accounts like inherited individual retirement accounts (IRAs). Over the last few years, Congress has passed two new laws that impact how inherited IRAs are treated. The first act—signed in 2019—was called the Setting Every Community Up for Retirement Enhancement (SECURE) Act, and its 2022 incarnation was dubbed SECURE 2.0. Let's look at how these laws changed the rules for handling inherited IRAs. 

Before we dive into the inherited IRA discussion, let's cover a few important facts about IRAs and other retirement accounts. The assets in an IRA receive special tax treatments that allow investments to potentially grow without taxes reducing returns. However, assets in an IRA cannot be left there forever; at some point, those assets need to be withdrawn. 

There are generally two types of tax-advantaged retirement accounts: Roth and tax deferred. Tax-deferred accounts, like traditional IRAs, have a mandatory annual distribution, or a required minimum distribution (RMD), once the original account owner reaches age 73. Roth IRA original account owners, on the other hand, don't have to take RMDs. When someone inherits an IRA or other retirement account, RMDs are generally required regardless of account type. 

So how soon does a beneficiary of an inherited IRA need to take RMDs? In the past, the rules were relatively straightforward, but the SECURE Acts have made the rules a bit more complicated. Let's take a high-level look at the rules to help clear things up. And if you want a deeper dive into this topic, check out Schwab's inherited IRA guide. 

Those who inherit a spouse's IRA have a unique choice, which the new laws did NOT change. The surviving spouse can make the inherited IRA their own and add the inherited IRA assets to their own IRA. However, keep in mind, it has to be the same type of IRA. For example, if the spouse had a Roth IRA, the inheriting spouse must transfer the funds into a new or existing Roth IRA in their own name. 

Assuming the inherited assets as your own may help preserve any potential tax benefits, including the opportunity for tax-deferred (traditional) or tax-free (Roth) growth. Another reason to consider this option is that you may be able to make additional contributions to help build your savings. When an investor makes inherited IRA assets their own, they'll start taking RMDs based on their age (either 73 as of 2023 or 75 starting in 2033). Those who are younger and don't need the inherited assets for living expenses can potentially avoid RMDs for many years. But those who need the money to pay expenses and are under age 59.5 may have to pay penalties for withdrawals if you make those assets your own. 

Those who inherit tax-deferred assets and add those assets to their IRA will have the option to convert them to a Roth account. This may make sense for those who expect their current tax rate to be lower than their tax rate in retirement. Keep in mind that, depending on the type of contributions your spouse made to their IRA, you'll have to pay taxes on the converted amount. Before converting, be sure to check your spouse's past tax returns to see if they included a Form 8606, which is used to report non-deductible IRA contributions. Non-deductible contributions aren't taxable when you do a Roth conversion because taxes have already been paid on the money. If neither the inherited IRA or your own personal IRA contain non-deductible contributions, then the full amount you convert to a Roth IRA will generally be taxable in the year you do the conversion. 

Here are several other choices a surviving spouse has after inheriting an IRA. Note that the SECURE Act changed "stretch IRA" payments for most non-spouse beneficiaries. 

1. Take life expectancy payments from an inherited (beneficiary) IRA. Instead of making the inherited assets your own, you can register the account as an inherited IRA in your name. Whether this makes sense depends on the type of IRA inherited (traditional or Roth), the deceased spouse's age, and the RMD rules. 

This route results in an annual RMD that must be withdrawn each year to avoid a 25% penalty. The distribution is calculated based on either the surviving spouse's life expectancy or the remaining life expectancy of deceased. 

Those who keep the account as an inherited IRA will still have the choice to switch the account assets over and make them their own. But once that's done, there's no turning back. 

When does the spouse have to begin taking the RMDs in an inherited account? The starting date depends on whether the decedent spouse had already reached their own RMD age (RBD) before passing away. 

• If the decedent spouse had reached their RMD age, the surviving spouse must take any remaining RMDs that the decedent spouse missed in the year of death. The surviving spouse must start taking their own life expectancy RMD in the year following the year of death and continue each year after that.  
• If the decedent spouse had NOT yet reached their RMD age, then the spouse has two alternatives for starting their life expectancy payments:     

1. By December 31 of the year following the year the original account owner died, or (if later)      
2. By the end of the year the original owner would've reached their RMD age  

Here are a few more considerations for inherited IRAs based on the type of IRA the surviving spouse inherits: 

1. Inherited tax-deferred IRA. Any distribution of pre-tax assets are generally taxable, but the 10% penalty for early withdrawals doesn't apply. And remember, there's up to a 25% penalty for any missed RMDs.
2. Inherited Roth IRA. Although the RMD for inherited Roth IRAs is similar to the RMD rules for inherited traditional IRAs, Roth IRA withdrawals are generally tax free as long as the original Roth IRA was open for at least five years. If inherited Roth IRA distributions aren't needed to cover living expenses, you could consider rolling over the inherited Roth assets into your own Roth IRA.
3. Take a lump-sum or random distributions. Those with an immediate need for the money can take all or a portion of the assets out. However, this means surrendering any tax benefits from keeping the money in an IRA (like the potential for tax-deferred or tax-free growth). Plus, if the assets are from a tax-deferred IRA, you may have to pay taxes on the amount you receive, which could push you into a higher tax bracket for that year.
4. Disclaim the inherited assets. Investors can also refuse all or some of the money from their spouse, allowing it to pass to the next beneficiary. 

Before moving forward with one of these distribution choices, it's a good idea to consult a tax professional to help navigate any tax implications. 

The SECURE Act eliminated "stretch IRAs" for many beneficiaries. With stretch IRAs, it was possible to take annual distributions based on the beneficiary's life expectancy over their lifetime, potentially allowing the assets to stay in a tax advantaged account longer. Now, many beneficiaries instead have to take RMDs based on the new 10-year rule, which requires all assets in the inherited IRA to be fully withdrawn by the end of the 10th year following the original account owner's death. 

For anyone who passed away in 2020 or later, only certain non-spouse beneficiaries, called eligible designated beneficiaries, are exempt from the 10-year rule and can still use a stretch IRA. There are five eligible designated beneficiaries: 

1. The spouse of the deceased
2. Chronically ill beneficiaries  
3. Disabled beneficiaries
4. Beneficiaries who are not more than 10 years younger than the deceased account owner
5. A minor child of the account owner (biological child or legally adopted) until age 21, after which they have 10 years to deplete the account 

If you're not an eligible designated beneficiary, a stretch IRA won't be an option, and you'll likely be covered by the new 10-year rule. This includes grandchildren and other family members who do not meet the exceptions above. Thus, instead of being able to stretch inherited IRA withdrawals over a lifetime, these non-eligible beneficiaries must deplete the account by the end of the 10th year following the decedent's passing. 

For beneficiaries who don't meet one of the five categories above, the 10-year rule kicks in if you inherited the account in 2020 or later. 

 Those who inherited the account before 2020 will still be covered by the old rules. 

The 10-year rule has two possible options:  

1. If the original IRA owner passed away after they were of RMD age, the beneficiary needs to take annual RMDs from the inherited IRA and have the account completely depleted before the end of 10 years.
2. If the original IRA owner passed away before reaching their RBD age, there is NO annual RMD, but the account will still need to be emptied before the end of 10 years. 

Of course, heirs can always draw down the account faster. In fact, in some situations, taking more out each year could result in less taxes overall. For example, if an inherited IRA contains only tax-deferred assets, withdrawing only RMDs could leave someone with a large balance in the 10^th year, causing a big bump in taxes. That's why we recommend working with a tax and financial advisor to help determine how much to withdraw each year. 

Carefully consider the available choices when deciding what to do with an inherited IRA. Consult with a knowledgeable retirement or tax professional who can take you through the alternatives and help you potentially limit any negative tax consequences.