Understanding Your Options as a Non-Spouse Beneficiary of an IRA BDA
Learn the withdrawal options and tax consequences for inherited IRAs.
Individual retirement accounts (IRAs) provide an excellent vehicle to save for retirement, making them a popular account type. As individual savers, our focus is usually on our own IRA accounts—making contributions, choosing investments, and planning taxes.
However, you may also inherit an IRA from someone else. This is a special circumstance that requires attention, because inherited IRA rules are different from the rules surrounding your own IRA. This is especially true if you inherit an account and are not the deceased accountholder’s spouse.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 made a significant impact on these rules. If you anticipate inheriting an IRA and already have a plan to address it, you may need to update that plan in light of the new rules.
What Is an IRA Beneficiary Distribution Account (BDA)?
An IRA Beneficiary Distribution Account, or IRA BDA, is more commonly referred to as an "inherited IRA." As the name suggests, an inherited IRA is one that you (the beneficiary) receive from another individual.
The IRS stipulates what you can do with an inherited IRA, depending on whether you are that person's spouse. These rules generally relate to how and when you must start taking required minimum distributions (RMDs) from the account.
Spouses have more flexibility than non-spouses when it comes to what they can do after inheriting an IRA. Namely, they can treat the IRA as their own, either by redesignating themselves as the account holder or by rolling it over into one of their existing IRAs.
Inherited IRA Rules Under the SECURE Act
The rules for inherited IRAs changed with the passage of the SECURE Act, and most of its provisions went into effect on January 1, 2020. The SECURE Act addresses many broad issues regarding retirement in addition to specific items related to inherited IRAs.
The SECURE Act now generally requires non-spouse beneficiaries to withdraw all of the money from an inherited IRA within 10 years of the account holder’s death.
This significant change essentially eliminates the stretch IRA, which allowed a beneficiary to distribute the account over their own life expectancy. The beneficiary was able to “stretch” the IRA—and defer its taxes—over a period often much longer than 10 years.
There are a few exceptions to this new standard when the IRA is inherited by one of the following:
- The surviving spouse
- A minor
- Someone who is disabled or chronically ill
- Someone not more than 10 years younger than the original IRA owner
These beneficiaries will have separate rules addressing how they can treat the inherited IRA and are not required to withdraw from the account within a 10-year period.
If you’re a non-spouse inheriting the IRA along with other beneficiaries, separate your portion of the IRA in your name. You must also take your first distribution by December 31 of the year following the death of the account holder. If you miss that deadline, the RMD will be calculated based on the life expectancy of the oldest beneficiary, forcing you to take a larger distribution if they’re older than you.
Rules for When the Account Holder Died Before January 1, 2020
Prior to the passage of the SECURE Act, your inherited IRA options depended on whether the original account owner died before or after they turned 701/2.
If the Account Owner Died Before Reaching 70 1/2
Under pre-SECURE Act rules, if the original account owner died before reaching the calendar year in which they would have turned 70 1/2, a non-spouse beneficiary could:
- Take the inherited IRA as a lump sum. You would avoid the 10% early withdrawal penalty even if you were under 59 1/2, but you’d still owe income tax.
- Distribute the account within five years of the original account holder’s death. You would be taxed on each distribution but would also avoid the 10% penalty.
- Distribute or stretch the account over their own life expectancy. Again, you’d be able to avoid the 10% early-withdrawal penalty, but you'd have to pay income tax.
If the Account Owner Died After Reaching 70 1/2
If the original account owner were age 70 1/2 or older when they died, under pre-SECURE Act rules, a non-spouse beneficiary could:
- Take the inherited IRA as a lump sum. This would tax your distributions all at once and maybe even put you in a higher tax bracket.
- Take distributions based on life expectancy: The RMDs can be based on your life expectancy or that of the original account holder, whichever is longer. There is no 10% penalty, and the RMDs are taxed at each distribution.
When to Consider Disclaiming an Inherited IRA
You don’t have to accept the assets from an IRA—you can disclaim the inheritance instead. When you disclaim an inherited IRA, it will go to the next beneficiary in line, so you won’t owe any taxes on it.
You have nine months from the original account owner’s death to disclaim the inherited IRA.
While it may seem odd to not accept an inheritance, some factors might make you consider disclaiming an IRA. These include when the beneficiary next in line for the IRA:
- Is in greater financial need than you
- Is in a lower tax bracket (which will result in less value being lost to taxes as the account is depleted over 10 years)
- Qualifies for one of the four exceptions listed above. These beneficiaries can withdraw from the account for more than 10 years, possibly reducing the total tax bill.
You might also want to avoid inheriting an IRA as it would become part of your estate and could drive up its value, possibly causing it to exceed the estate tax exemption amount.
Whether or not you disclaim an inherited IRA can have a significant impact on your taxes, so make sure you discuss this with your tax professional.
The Bottom Line
The SECURE Act significantly changed non-spouse beneficiaries’ options for how and when to receive inherited assets. If a friend or family member has chosen you as a beneficiary of their traditional or Roth IRA, review your options carefully. See how they fit into your overall financial plan to determine the best course of action for you and your wallet.