It is estimated that $30 trillion of intergenerational wealth will be passed down over the next decades, creating both opportunities and risks those inheriting these potentially large sums of money. Some of these transfers will come in the form of a Self-Directed Inherited IRA (a.k.a. a Beneficiary IRA), which will allow inheritors/beneficiaries to manage these inheritances that are passed down to them in the form of a retirement account.
Self-Directed Inherited IRAs allow the deceased account holders to pass along tax-advantaged savings to their heirs. Unfortunately, the first time most recipients become aware of a Self-Directed Beneficiary IRA is when they suddenly inherit a retirement account. Since it is someone else’s retirement plan, a Self-Directed Inherited IRA can be confusing to those who receive it, and it can generate many questions: What are my options with this account? What about taxes? How can I merge this inheritance into my own financial plan?
As baby-boomer heirs participate in the largest wealth transfer in history, it is more important than ever that they understand the details of the Self-Directed Inherited IRA. First of all, you will need to distinguish between a Self-Directed IRA you inherit from your spouse and one you inherit from a parent, sibling or someone else.
Here is what you need to know:
Inheriting a Traditional IRA from your spouse
Inheriting a Self-Directed IRA from your spouse is the simplest and most pain-free scenario. You can roll over the Self-Directed Inherited IRA into your existing IRA, and the earnings will continue to grow tax-deferred. You will pay no income taxes unless you take a distribution, and if you are older than 59 ½, you won’t owe the 10% tax penalty on early withdrawals.
Rolling over a Self-Directed Inherited IRA is attractive because you immediately gain control over the distributions. A word of caution, however: If you are at least 70 ½, make sure you adjust the amount of your annual Required Minimum Distribution (RMD) to include the amount from the Inherited IRA. Some special RMD rules apply to Self-Directed Inherited IRAs, and there are steep penalties for not following them!
Also, remember that if you do decide to take a Self-Directed Inherited IRA distribution, it could send you into a higher tax bracket because the money will now be earned income. If you would rather invest the money, talk to your financial advisor about incorporating the inheritance into your overall financial plan.
If you are a non-spouse inheritor
You will need to pay income taxes on distributions from the Inherited Traditional IRA. But you may not roll the Self-Directed Inherited IRA into an existing Self-Directed IRA, and you must begin withdrawing the assets no later than December 31st of the year after the account holder passed away.
Once again, these distributions are considered to be part of your annual income and could put you into a higher tax bracket. And if you do not take the necessary distributions, you will suffer a 50% tax penalty on the amount taken out below the RMD!
Self-Directed Inherited IRA distribution rules
Beneficiaries of Self-Directed Inherited IRAs can choose distributions from three options:
- Take distributions as an RMD over the course of their lifetime (life expectancy method)
- Take them over a five-year period
- Receive a lump sum.
The life expectancy option means an RMD will be set each year by the IRS, and you must make them to avoid the penalty.
The five-year option allows you to withdraw the funds over five years. There are no RMDs, and there is no early withdrawal penalty. After five years, all remaining funds must be withdrawn.
The lump sum distribution means a full payout of the account immediately after inheriting the Self-Directed IRA. While there is no 10% early withdrawal penalty, you will still owe income taxes.
What are the rules for Self-Directed Roth IRAs?
Since the Self-Directed Roth IRA was funded with post-tax income, the inheritor will not pay income tax on distributions, and the distributions will not count as taxable income when determining your tax bracket.
If you elect to take the life expectancy method, however, any distributions that fall below the RMD will still be subject to the 50% penalty.
Turn to the pros when you are ready to invest your Self-Directed Inherited IRA
At American IRA, we believe that Self-Directed IRAs are the best vehicles for growing your retirement account. And we have the experience to help you with your transactions.