Few people would complain about receiving an inheritance, including one in the form of an IRA. However, there are some rules that you’ll have to follow if you inherit an IRA, and they may create some unintended tax consequences.
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If you don’t adhere to the rules, you could face even more severe penalties, thanks to changes in tax laws in 2020. Here’s a look at the most important rules you need to know regarding inherited IRAs.
What Must You Do If You Inherit an IRA?
If you’re the non-spouse beneficiary of an IRA, you essentially have two options. The first is to open your own, separate inherited IRA account. Upon providing proper documentation, including a death certificate, you can have the assets transferred into this new inherited IRA account. Note that you are not allowed to transfer the assets into an existing IRA account, if you have one.
The second option is to take a lump sum distribution. This means that you take the full amount of your inheritance in cash and do not put it into an IRA. If you inherit a traditional IRA, this can create serious tax consequences.
In most cases, you’ll have to pay ordinary income tax on the full amount of the distribution. Depending on the size of the account, this may even kick you up into a higher tax bracket, causing you to lose even more of your inheritance.
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How Have Distribution Rules Changed?
Before 2020, if you inherited an IRA, you weren’t required to take your first distribution until Dec. 31 of the year after the original account holder died. From there, you were required to take annual distributions based on your life expectancy. This allowed beneficiaries to spread out the tax hit over their entire lifetimes.
However, things changed in 2020. Now, there’s a 10-year rule in effect for inherited IRAs. Non-spouse beneficiaries must withdraw the entire amount of an inherited IRA within 10 years. This results in a larger tax obligation over a shorter period of time. It also results in less time to allow assets to grow tax-deferred within the account.
Imagine, for example, that you’re a 40-year-old and you inherit an IRA. Under the old rules, you could slowly distribute that IRA over 30, 40 or even 50 or more years, growing the remaining balance on a tax-deferred basis as you wait and paying minimal taxes. But thanks to the changes that went into effect in 2020, you’ll now have to drain that IRA within 10 years, accelerating your tax liability.
Note that if you inherit a Roth IRA, you won’t generally have to pay taxes on your distributions. However, if the original account was open for less than five years, you may still have a tax liability, per the IRS.
Rules Are Different If You Are the Spouse of the Decedent
If you’re a non-spouse beneficiary of an IRA, you must create a new inherited IRA and transfer the money into it. But if you’re the spouse of a decedent, you have two options: You can either create a new inherited IRA or you can simply roll the decedent’s IRA into your own, existing IRA.
Perhaps more importantly, spouse beneficiaries are not subject to the 10-year mandatory distribution rule. Rather, you’re allowed to distribute the IRA according to your own original schedule. For a traditional IRA, this means you can take distributions over your lifetime, rather than over 10 years. For a Roth IRA, no mandatory distributions are required, so you can keep the money in your account for as long as you desire.
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This article originally appeared on GOBankingRates.com: Rules You Need To Know Regarding Inherited IRAs
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