(800) 644-1150

Know This Before You Transfer Assets to Your Heirs

Here at Lucia Capital Group, we do a lot of work with clients who are planning to pass their assets to their heirs once they’re gone – usually it’s their kids, but not always. In either event, it’s important to know what the benefits and consequences are of inheriting tax-deferred retirement accounts.  

It’s that “tax-deferred” characteristic that can trip some people up, either because they didn’t know the rules, or because they didn’t think those rules applied to their situation.  

Whenever you inherit an IRA or a 401k or other tax-deferred retirement account, you will ultimately be required to take a minimum amount of money out and pay taxes on it. This is true regardless of the age at which you inherit the asset. The question is, when do you have to start taking those RMDs, and when do they end? 

Here are some things you need to know. 

First, if you’re a surviving spouse, you have some flexibility when you inherit an IRA. Typically, you can either transfer the assets to your own IRA, at which point you then become the new owner, or you can simply treat it as an inherited IRA. But keep in mind that if you make yourself the new owner, if you’re under age 59½ and you need to access the money, you’ll have to pay a 10% early withdrawal penalty for doing so.  

On the other hand, if you leave it in your deceased spouse’s name and you treat it as an inherited IRA, there are no RMDs for you until that spouse would have reached their own RMD age (either age 73 or 75, depending on their birth year). With this option, since you are not the owner of the inherited IRA, there are no penalties for distributions before you reach age 59 ½.   

Okay, that’s for spouses. For non-spouses, the rules are different – and a bit more complicated.  

When you inherit an IRA, as a non-spouse, you’ll have a required minimum distribution on that inherited IRA, even if you’re nowhere near your RMD age, and this includes inherited Roth IRAs.  

Also, as a non-spouse, you’re not allowed to transfer or rollover funds from an inherited IRA directly into your own IRA. When you distribute funds for any reason, it’s like receiving a check that’s payable to you, and it’s a taxable distribution. You also can’t do a 60-day rollover with inherited IRA funds, nor can you convert them to a Roth. Yes, these rules are tight.  

But – there is no 10% early withdrawal penalty on an inherited IRA. You’ll be taxed on any funds you take out (unless it’s a qualified Roth distribution), but you won’t have a penalty.  

Now here’s where the complexity really kicks in:  

If the IRA owner died prior to 2020 and they had not yet reached RMD age, then you have two options as the non-spouse beneficiary. First: you can take an RMD every year starting the year after the IRA owner died, based on your life expectancy, and stretch it out over that period of years until it’s gone.    

The second option is to completely distribute the IRA — in other words, take all the money out — by the end of the 5th tax year after the owner’s death. Normally, if the inheritor doesn’t need all the money, this option is necessary when the beneficiary misses the first RMD. So if you miss an RMD in the first few years, then the entire IRA must be distributed within that five-year window.   

But if the person who died WAS of RMD age – then there’s no five-year option. You MUST take an RMD out every single year or you’ll be assessed a penalty for missing it. – and the penalty can be as much as 25% of the shortfall (thankfully, this has recently been reduced from 50%).  

Okay: but what if the owner of the IRA died in 2020 or later? Well, most non-spouse beneficiaries no longer have the lifetime “Stretch” option.  In most cases, the entire IRA will need to be distributed by the end of the 10th tax year after the owner’s death. Unless the deceased owner already had an RMD, there’s no minimum amount you’d need to take out in years 1-9, but if the deceased owned was at RMD age, then the beneficiary will have RMD in years 1-9. In either case, 100% of the money must be distributed by the end of the 10th year.    

Now, this 10-year clock doesn’t begin for a beneficiary who is a minor until they reach the age of majority, as defined by the IRS.  And these new “no-stretch” rules don’t apply to beneficiaries who are less than 10 years younger than the owner, or to beneficiaries who have a chronic illness, or who are disabled (as defined by the IRS).  

And even if you don’t have to take any money out of the inherited IRA for some period of time, you may still want to, just so you won’t have a large distribution that is all taxable in the last year. 

Hey, we told you it was complicated! 

So why is this important? Because making mistakes or violating the rules could create a lot more taxes and penalties for you. You need someone advising you who is familiar with the rules, the benefits, and the consequences of all the various scenarios I just laid out.   

We deal with things like this every single day. If you’re in a situation where you’re inheriting taxable assets, or you plan on giving taxable assets to anyone after you’re gone, it’s a really good idea to talk it over with one of our advisors so we can help you to avoid paying any unnecessary taxes and penalties.  How can we help you the most?  Just give us a call! 

Important Information:

The information provided should not be considered specific tax, legal, or investment advice and is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

No client or prospective client should assume that this information, or any component thereof, serves as the receipt of, or a substitute for, personalized advice from Lucia Capital Group or from any other investment professional.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

IRA withdrawals will be taxed at ordinary income rates. Withdrawals prior to age 59½ may also be subject to a 10% penalty tax.

Roth IRA distributions of principal from a Roth IRA are tax-free; however, any earnings will be taxed at ordinary income rates and a 10% penalty tax will apply if withdrawn prior to age 59½ or within five years of the date the Roth IRA was established, whichever is longer.

Rick Plum is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor and member FINRA/SIPC. The investment professionals are affiliated with LPL Financial and are conducting business using the name Lucia Capital Group, a separate entity from LPL Financial.

Start Your Strategy

Personalized investment advice and support to help grow your portfolio