Understanding Your Options as a Non-Spouse Beneficiary of an IRA BDA

Learn the withdrawal options and tax consequences for inherited IRAs

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Individual retirement accounts (IRAs) provide a great way to save for retirement. They're a popular type of account for many. But our focus is often on our own IRA accounts—making contributions, choosing investments, and planning taxes. You might also inherit an IRA from someone else.

Inherited IRA rules are not the same as the rules for your own IRA. This is even more true if you inherit an account and you aren't the deceased's spouse. 

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 made a big impact on these rules. You may need to update your plan in light of these rules if you think you might inherit an IRA, and you think you already know what you're going to do with it.

What Is an IRA Beneficiary Distribution Account?

An IRA Beneficiary Distribution Account (IRA BDA) is often referred to as an "inherited IRA." It's one that you receive as a beneficiary from another person.

IRS rules dictate what you can do with an inherited IRA, depending on whether you're the deceased's spouse. These rules relate to how and when you must start taking required minimum distributions (RMDs).

Spouses have more flexibility here than non-spouses. They can treat the IRA as their own, either by designating themselves as the new account holder or by rolling it over into one of their own existing IRAs.

Inherited IRA Rules Under the SECURE Act

The rules for inherited IRAs changed with the passage of the SECURE Act. Most of these changes went into effect on Jan. 1, 2020. The SECURE Act addresses many broad issues for retirement, as well as certain factors related to inherited IRAs. Non-spouse beneficiaries must withdraw all the money from an inherited IRA within 10 years of the account holder’s death since the passage of the Act.

The SECURE Act often requires that non-spouse beneficiaries withdraw all the money from an inherited IRA within 10 years of the account holder’s death.

This change more or less eliminates the stretch IRA. This type of IRA allowed a beneficiary to distribute the account over their own life expectancy. The beneficiary was able to “stretch” it. They could defer tax on that money over a period that was often much longer than 10 years.

There are a few exceptions to this standard if the IRA is inherited by the surviving spouse, a minor, someone who is disabled or chronically ill, or by someone who's not more than 10 years younger than the original IRA owner. These beneficiaries are subject to their own rules for how they can treat the inherited IRA. They're not required to withdraw from the account within a 10-year period.

Separate your portion of the IRA in your name if you’re a non-spouse inheriting the IRA with other beneficiaries. You must also take your first distribution by Dec. 31 of the year following the death of the account holder. The RMD will be figured based on the life expectancy of the oldest beneficiary if you miss this deadline. This will force you to take a larger distribution if they’re older than you are.

If Account Holder Died Before Jan. 1, 2020

Your options depended on whether the original account owner died before or after they turned 70½ before the passage of the SECURE Act.

The Account Owner Died Before Age 70½ 

A non-spouse beneficiary could take a few actions if the account owner died before reaching the calendar year in which they would have turned 70½. They could take the inherited IRA as a lump sum in this case. They would avoid the 10% early withdrawal penalty even if they were younger than age 59½, they still would owe income tax on the money.

They might instead distribute the account within five years of the original account holder’s death. They would be taxed on each distribution in this case. But they would avoid the 10% penalty as well.

Another choice would have been to distribute or stretch the account over their own life expectancy. Again, they'd be able to avoid the 10% penalty. But they'd have to pay income tax on the money.

The Account Owner Died After Age 70½ 

A non-spouse beneficiary also had a few options under pre-SECURE Act rules if the account owner died after reaching age 70½. They could take the inherited IRA as a lump sum. This would tax the money all at once. It might put them in a higher tax bracket.

Or they could take distributions based on their own life expectancy instead. RMDs could be based on that or on the life expectancy of the deceased account holder, whichever was longer. There would have been no 10% penalty. The RMDs would be taxed at each distribution.

Should You Disclaim an Inherited IRA?

You don’t have to accept the assets from an inherited IRA. You can disclaim the inheritance instead. It would go to the next beneficiary in line so you won’t owe any taxes on it if you disclaim it.

You have nine months from the original account owner’s death to disclaim the IRA.

It may seem odd to not accept an inheritance, but some factors might make you think about it. These include the beneficiary who is next in line for the IRA being in greater financial need than you, or maybe they're in a lower tax bracket. This would result in less value being lost to taxes because the account could be depleted over 10 years.

Another factor might be that the next beneficiary qualifies for one of the four exceptions. They can withdraw from the account for more than 10 years, again reducing the total tax bill.

You might also want to avoid inheriting an IRA because it would become part of your own estate. This could drive up your estate's value, possibly causing it to exceed the estate tax exemption amount. 

Discuss the matter with a tax professional before you decide. Disclaiming an inherited IRA can have a big impact on your taxes.

The Bottom Line

The SECURE Act made some big changes to non-spouse beneficiaries’ options for how and when they want to receive inherited assets. Review your options carefully if a friend or family member has chosen you as a beneficiary of their traditional or Roth IRA. See how it fits into your overall financial plan to decide on the best course of action for you and your wallet.