How Do Inherited IRAs and Inheritable Investment Accounts Work?

Understanding inherited IRAs and investment accounts

What is an inherited IRA or inheritable investment account

An inherited investment account is an account that transfers to a beneficiary when the original owner passes away. These accounts can include:

• Traditional IRAs
• Roth IRAs
• Employer retirement plans, such as 401(k)s
• Taxable brokerage accounts
• CDs or annuities

You cannot contribute any new money to an inherited IRA, but you can decide how and when to withdraw funds under IRS rules that vary depending on the inheritor and account type. Each account type has different tax considerations, so fully understanding which account type you inherited is a great starting point to help you begin planning any next steps.

How inherited IRA rules work

Inherited IRAs follow rules set by the IRS. These rules depend on the type of IRA and whether the beneficiary is a spouse, non-spouse, minor child or another eligible person. The SECURE Act of 2019 and the SECURE 2.0 Act of 2020 changed many of these rules, so both designated and undesignated beneficiaries often need to understand new timelines and requirements.

Inherited traditional IRAs

Traditional inherited IRAs are taxable when you take withdrawals. For most non-spouse beneficiaries, the account must be fully withdrawn within 10 years. This is known as the 10-year rule, which applies to most designated beneficiaries. The five-year rule typically applies to non-designated beneficiaries. The timing of your withdrawals can affect the taxes you owe, so many beneficiaries spread withdrawals over several years in consideration with any other sources of income.

Inherited Roth IRAs

Withdrawals from inherited Roth IRAs are typically tax-free so long as the original account met the five-year holding requirement. Even though withdrawals may not be taxable, most beneficiaries still need to empty the account within 10 years unless they qualify for an exception.

Spouse beneficiaries

A spouse beneficiary has more flexibility than any other type of beneficiary, in which spouses can:

• Treat the IRA as their own

• Roll the funds over into an existing IRA

• Open an inherited IRA and follow current withdrawal rules

This flexibility allows spouses to choose an option that fits their retirement plans, tax situation and financial goals.

Non-spouse beneficiaries

Non-spouse beneficiaries must open an inherited IRA and cannot combine the funds with their own retirement accounts. Many must follow the 10-year rule, although some exceptions exist for eligible beneficiaries such as minor children, disabled individuals or those close in age to the original owner.

As mentioned above, there is also a five-year rule for specific circumstances primarily surrounding non-designated beneficiaries where the owner dies before the required beginning date (such as a trust or estate).

What does the 10-year rule mean for inherited IRAs

The SECURE Act of 2019 created the 10-year rule for many inherited IRAs. In summary, this rule means you must withdraw the full balance by the end of the tenth year after the account owner’s death.

Some beneficiaries may also need to take required minimum distributions during those 10 years if the original owner had already started taking required minimum distributions (RMDs) on the inherited investment account. Other beneficiaries can take withdrawals in any pattern as long as the account is fully distributed by year 10, providing an opportunity to balance withdrawals with your current taxable income. The 10-year rule does not require equal withdrawals, providing the flexibility to time distributions around your goals.

Understanding RMDs for inherited IRAs

Required minimum distributions, or RMDs, depend on when the original account holder passed away and whether they had begun RMDs. If the owner had started RMDs, then you may need to continue taking annual withdrawals based on IRS guidance.

If the owner had not yet begun RMDs, there may be more flexibility. Some beneficiaries only need to follow the 10-year rule, while others may need to take annual distributions. These rules can be complex, so it is best to take the time to fully understand the rules surrounding your inherited assets to ensure you avoid any unnecessary taxes or fees. IRS Publication 590-B provides detailed guidance surrounding inheritance to help beneficiaries understand which rules apply to them.

How inherited 401(k)s and employer plans work

When you inherit an employer-sponsored retirement plan, such as a 401(k), you may be presented with several options depending on your situation. These can include:

• Keeping the funds in the employer plan
• Rolling the balance into an inherited IRA
• Taking a lump-sum withdrawal

Many beneficiaries choose to roll an inherited 401(k) into an inherited IRA because it often simplifies management of the account and may provide more investment choices. Distribution rules for inherited 401(k)s follow similar guidelines to inherited IRAs, including the 10-year rule for many beneficiaries.

What happens when you inherit a taxable brokerage account

Taxable brokerage accounts follow a different set of rules than IRAs. When you inherit a taxable investment account, the cost basis of the investments typically receives a step-up in basis. A step-up in basis means that the value of the investment is reset to its current market value on the date of death. In practice, this means that the beneficiary will now only owe taxes on any capital gains from the date of inheritance, instead of owing capital gains on the lifetime appreciation of the investment account.

A step-up in basis can reduce or eliminate any capital gains tax if you decide to sell the investments soon after inheriting them, as well as provide a lower basis of capital gains tax in the future if you decide to hold the asset(s). You can usually sell or withdraw funds at any time because taxable accounts do not have early withdrawal penalties. That said, you will still owe taxes on any dividends, interest or capital gains earned after the date of death.

To illustrate a step-up in basis as simply as possible, imagine your parent had an investment account in which they had invested $100K and the account had appreciated to $300K by their death. Instead of owing tax on the $200K of capital gains upon inheritance, the step-up in basis shifts the value of the assets to their current market value on the day of death. In this example, the inheritor would now hypothetically owe taxes on any capital gains over the $300K mark. This means that if they later sold the assets for $400K, they would only owe taxes on that $100K of capital gains.

Inheriting annuities, CDs and other investment types

Annuities

Annuities may continue to grow tax-deferred, but earnings are taxed as ordinary income when withdrawn. The specific distribution rules depend on the contract and whether the beneficiary is a spouse.

Certificates of Deposit

CDs can transfer to beneficiaries, but the interest may be taxable. Some institutions waive early withdrawal penalties for beneficiaries, but this varies by institution and situation.

Other managed accounts

Managed accounts or trust-owned accounts follow the instructions outlined in the trust or the original account agreement. Beneficiaries may need to follow the rules set by trust documents in addition to all applicable IRS guidelines.

Choosing the right distribution strategy for you

There is no “right way” to take distributions from an inherited account. Your options depend on your current and future expected tax bracket, financial needs, other investments, and financial goals. Depending on your situation, you may choose to withdraw smaller amounts over several years to help manage taxes or delay withdrawals, if allowed, to give the account more time to grow. Some individuals also choose to take earlier withdrawals if they need funds for expenses, or long-term savings goals like a down-payment for a house. Comparing different scenarios and weighing your options thoroughly can help you decide on the approach that works best for you.

When to seek guidance on inherited assets

Inherited investment accounts and the rules surrounding them can be complex, especially when you are trying to navigate different tax rules, distribution requirements and decisions about timing. A financial professional can help you understand which rules apply to your situation and help you compare potential strategies before taking action. For more information on estate and wealth planning, review Associated Bank’s offerings or get connected with a financial professional that can explain your options and help you compare strategies based on your goals.