Reviewing Non­Spouse IRA Beneficiary Rules

At the end of last year, Congress was considering tying up a tax revenue loophole known as the Stretch IRA. Currently, a traditional IRA can be passed from one generation to the next, thereby extending tax-deferred growth to a non-spousal beneficiary. In recent months, Congress has been distracted by budget bills and healthcare legislation; but as Congress turns its attention to tax reform in the coming months, this loophole could be on the table again.

Currently, when a spouse inherits an IRA from a recently deceased partner, he or she is permitted to treat it as his or her own. This is a bit of a misnomer because the surviving spouse must first transfer the assets to his or her own IRA – or open a new account if he or she doesn’t have one. Once those assets are transferred, the spouse can take withdrawals at any time; however, IRA rules still apply. He or she is responsible for all taxes levied on withdrawals as well as an additional 10 percent penalty on money withdrawn before age 59½ (traditional IRA).

A non-spouse beneficiary, such as a child or grandchild, has a couple of different options depending on whether his or her parent had begun taking required minimum distributions from the IRA by the time he or she died. This is likely if the IRA owner was 70½ or older. If distributions had begun, the non-spouse beneficiary must continue taking those RMDs by the last day of the year the parent died based on whichever is longer – his own life expectancy or the deceased parent’s remaining life expectancy.

By recalculating distributions to reflect the beneficiary’s life expectancy, a younger beneficiary might receive a smaller amount per distribution – but it will be over a longer period of time. This also allows tax-deferred growth to continue compounding for a potentially larger inheritance over time. Also note that the non-spouse beneficiary should designate a new beneficiary to the account in the event he or she passes away before the account is depleted or closed.

If the original IRA names two or more beneficiaries, each of them should establish their own separate IRA by the end of the year following the year of the owner’s death so that proceeds can be divided accordingly. If assets remain in the original account by the end of the year, distributions will be recalculated based on the life expectancy of the oldest beneficiary.

If the original IRA owner had not begun taking RMDs by the time of his or her death, the non-spousal beneficiary must either start taking minimum withdrawals by the end of the year or withdraw all the money by the end of five years. If there are two or more non-spouse beneficiaries, each one can transfer his share of the inherited account into an IRA in his own name and distributions will be based on each new owner’s life expectancy.

Note that in both cases, the original parent’s IRA also can be distributed as a lump sum. With a traditional IRA, the beneficiary is responsible for the income taxes on assets because they have never been taxed before. All original contributions and gains are taxed as ordinary income. Since a Roth IRA is funded with taxable contributions, no taxes are owed on either original contributions or gains. Be sure to talk with your Lewis & Knopf advisor for more information.