When establishing an IRA (including traditional, SEP, and SIMPLE) or qualified plan account, it’s important to designate beneficiaries to inherit your assets when you pass away. In addition, when life events such as marriage, divorce, or birth of a child occur, this is typically a good time to review and update your beneficiaries accordingly. Upon your passing, your beneficiaries will be required to take distributions from their inherited IRAs, but the payout period and applicable rules depend on who is designated as beneficiary. While the same rules generally apply for both IRAs and qualified plans, a plan document may dictate or limit payout options.

The enactment of the SECURE Act (effective January 1, 2020) brought several changes to inherited IRA rules. The following charts will outline inherited IRA distribution options if the account owner passed away in 2020 or after or prior to 2020:

Inherited IRA Options Based on Beneficiary (for death occurring 2020 or after)

¹ If you reached age 72 between 2020 and 2022, the required beginning date is April 1 of the year after reaching age 72.
² Five-year rule does not require a distribution in any year, but the inherited account must be fully distributed by December 31 of the fifth anniversary of death.
³ Distributions before age 59½ may be subject to a 10% penalty.
⁴ Non-spouse beneficiary exceptions that may still take RMDs over their life expectancy include disabled and chronically ill individuals, minor children of the deceased account owner, and non-spouse beneficiaries who are no more than 10 years younger than the deceased. Please note, once minor children reach the age of majority in their state, the ten-year rule will apply.
⁵ Does not require a distribution in any year, but the inherited account must be fully distributed by December 31 of the tenth anniversary of death.
⁶ Certain trusts, including charitable remainder trusts and “see-through” trusts benefiting an eligible beneficiary, may avoid the ten-year rule and allow for longer payout periods. If naming a trust as beneficiary, it is important to consult with a trust attorney.

Inherited IRA Options Based on Beneficiary (for death occurring prior to 2020)

¹ Prior to 2020, the required beginning date was April 1 of the year after reaching age 70½.
² Five-year rule does not require a distribution in any year, but the inherited account must be fully distributed by December 31 of the fifth anniversary of death.

SUCCESSOR BENEFICIARIES

Beneficiaries who inherit IRAs and qualified plans may designate successor beneficiaries to inherit the account when that primary beneficiary passes away. If the original account owner died in 2019 or prior with a non-spouse beneficiary that passes away in the future, the successor beneficiary will be subject to the ten-year rule upon the primary beneficiary’s passing. If the original account owner died in 2020 or after with a non-spouse beneficiary that passes away in the future, the successor beneficiary will continue the original beneficiary’s ten-year rule. (Note: The 10 years does not reset.)

IMPORTANCE OF STRETCHING AN IRA

The stretch strategy is utilized by having the IRA owner and beneficiaries distribute only their RMD each year. This allows the IRA to continue to compound earnings in a tax-deferred manner over the life expectancy of both the IRA owner and primary beneficiary, thus stretching the IRA over a maximum period of time and minimizing taxation each year. Generally, IRA and qualified plan owners that passed away in 2019 or prior may allow their beneficiaries to utilize the stretch strategy. For death occurring in 2020 or after, spouse beneficiaries and certain non-spouse exempt beneficiaries may take advantage of the stretch strategy.

DISTRIBUTION TAXATION AND PENALTIES

Although distributions are taxed as ordinary income at the beneficiary’s rate, the 10% penalty for distributions before age 59½ is waived for inherited IRA distributions. However, failure to take an RMD by the deadline (typically December 31 each year) will result in a 25% penalty on top of ordinary income tax for the undistributed amount. RMDs from inherited IRAs generally begin in the year after death, unless the deceased had not fully satisfied his or her RMD prior to passing. If the deceased had not fully satisfied his or her RMD, the beneficiary(ies) must generally satisfy it by December 31 of the year the IRA or qualified plan owner passed.