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) are a great way to accumulate assets in a tax-advantaged account. However, when the original owner of an IRA dies and passes the account to you, there is a new set of rules that guides how and when account distributions must occur. If you are named as a non-spouse beneficiary for an IRA Beneficiary Distribution Account (BDA), you need to fully understand your options so that you can make the decision that is best for your overall financial plan.
Basics of IRA Beneficiary Distribution Accounts
An IRA BDA is another name for an inherited IRA, which could be a traditional, rollover, SEP, SIMPLE, or Roth IRA. When you inherit an IRA, there is a special set of tax rules that determine how and when you must take annual distributions. The specific rules you must follow depend on whether you are a spouse or non-spouse beneficiary.
If you are the surviving spouse of the original IRA account owner: You generally have more options for handling inherited IRA assets as a surviving spouse. You can elect to treat the IRA BDA as your own account by designating yourself as the account owner, roll over the assets into a rollover IRA or a qualified retirement plan, or treat yourself as the beneficiary and take distributions.
If you are a non-spouse beneficiary: You can't elect to treat the account as your own or carry out a traditional rollover. But you have several options to choose from that depend on the type of IRA BDA account you are inheriting (traditional IRA or Roth IRA, for example) and the age of the account holder.
Using the IRA BDA of Someone Under 70.5
Consider these options if you are a non-spouse beneficiary of a traditional, rollover, SEP, or SIMPLE IRA whose account owner died before reaching his required beginning date (the year the person turned 70.5).
This option does not require you to set up a separate account in your name, as all of the money in the IRA BDA goes to you at once and you will pay income taxes on the distribution all at once.
You won't be on the hook for the 10% early withdrawal penalty if you are under age 59.5, but you will still have to pay income taxes on the distribution. This choice may push you into a higher tax bracket, so consider whether other distribution options make more financial sense.
Distribution Over Your Life Expectancy
This method requires you to move money from the IRA BDA into an account in your name. You'll generally have to start taking required minimum distributions (RMDs) by no later than the end of the year after the death of the account holder. You'll spread the RMDs over your single life expectancy (determined by your age in the calendar year following the year of death and reevaluated each year).
You would also need to establish separate accounts by September 30 of the year following the year of death in the event that multiple beneficiaries were named; otherwise, distributions will be based on the oldest beneficiary.
Each RMD will be taxed, but again, the 10% early withdrawal penalty doesn't apply. You can continue to enjoy tax-free growth on the assets in the IRA BDA.
Distribution Over a Five-Year Period
Choosing this option also involves transferring the IRA BDA assets into an account in your name. However, it enables a longer timeframe for the distributions should you wish to delay income from the inherited IRA. Under the five-year rule, you have to withdraw all of the funds from the BDA IRA by December 31 of the fifth year following the IRA account owner's death.
This doesn’t have to be done on an installment basis, but you must withdraw all of the funds before the applicable date, at which point the entire account must be depleted. Each distribution will still be treated as taxable income, but remaining assets continue to grow tax-deferred for up to five years, allowing you to postpone your tax liability should you choose.
Receiving an IRA BDA From Someone 70.5 or Over
As a non-spouse beneficiary of a traditional, rollover, SEP, or SIMPLE IRA from someone who died after her required beginning date, you have two main options for taking distributions from the account.
This option does not require you to set up a separate account, as the full IRA BDA balance will be distributed to you. While you will not incur the 10% early withdrawal penalty if you are under age 59.5, you will still have to pay income taxes on the distribution.
This might create some tax issues because the distribution may potentially move you into a higher tax bracket. Deciding if a lump-sum distribution makes sense for you ultimately depends on the amount of the distribution and your current income level.
If you're a high earner, you may want to consider one of the tax-deferred distribution strategies over the lump-sum option to spread out your tax burden.
Distribution Over Your or the Owner's Life
Receiving inherited assets through the life expectancy method allows you to transfer the money from the IRA BDA into an account held in your name. You generally must begin taking annual RMDs by the end of the year following the original account holder's death. However, if the account owner did not take their RMD in the year of death, RMDs must be taken by the end of the year the original account holder died.
Once RMDs begin in the inherited IRA, you can spread those annual distributions over whichever period is longer: your single life expectancy (determined by your age in the calendar year following the year of death and reevaluated each year) or the original account owner’s remaining life expectancy. This option is often referred to as a "Stretch IRA" because of the ability to extend distributions over your life expectancy while still having the ability to take out more than the RMD if desired.
In the event the account holder named multiple beneficiaries, separate accounts would need to be established by September 30 of the year following the year of death. Otherwise, distributions will be based on the oldest beneficiary.
You will be taxed on each distribution, but you will not face the 10% early-withdrawal penalty. Another benefit is that assets remaining in the account can continue to grow on a tax-deferred basis.
You also may elect to designate your own IRA beneficiary or multiple beneficiaries for your inherited IRA.
Inheriting a Roth IRA
If you inherit a Roth IRA as a non-spouse, you will generally have the same options for the account as you would have for a non-Roth IRA account when the owner dies before age 70.5, but with a different tax treatment.
Similar to Traditional IRA rules, the lump-sum option does not require you to set up a separate account; beneficiaries of a Roth IRA may receive all assets in the Roth BDA IRA at once. Roth IRAs also allow for tax-free and penalty-free withdrawals as long as the account is at least five years old and the original owner is at least 59.5. If the account is less than five years old at the time of the original account holder’s death, earnings are considered taxable income.
Distribution Over Life Expectancy
Non-inherited Roth IRAs have a unique feature in that they do not have RMDs during the original account owner’s lifetime. Inherited Roth IRAs, in contrast, have mandatory RMDs. When you choose this option, the IRA BDA assets will get transferred to an inherited IRA in your name and the RMDs must begin by December 31 of the year following the account owner’s death.
RMDs are also spread over your single life expectancy as the beneficiary. In the event that there are multiple beneficiaries, separate accounts must be established. If not, distributions will be based on the life expectancy of the oldest beneficiary. The good news: Distributions may be withdrawn without being taxed as long as at least five years have elapsed since the original owner set up and contributed to the account. There are no 10% early withdrawal penalties, and assets within the account continue to grow tax-free.
Distribution With the Five-Year Method
This IRA BDA option establishes an IRA in your name and gives you up until the end of the fifth year after the original account owner’s death to take distributions. At that point, the entire inherited IRA must be fully distributed. While distributions may be spread out over time, the length of time is much shorter than the life expectancy method. You can still allow those assets to grow tax-free for up to five years.
The Bottom Line
IRA BDAs grant non-spouse beneficiaries considerable flexibility and control over how and when to receive inherited assets. In the event that a friend or family member has chosen you as a beneficiary of her traditional or Roth IRA, carefully review your options and how they fit into your overall financial plan to determine the course of action that's best for you and your wallet.