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Inherited IRA Rules (Updated for 2020 to Reflect SECURE Act and CARES Act)

As a result of the SECURE Act that was passed in late 2019, there are now essentially two sets of rules for inherited IRAs. Which rules to use depends on a) when the original account owner died and b) who is listed as the beneficiary of the account.

Also, as a result of the CARES Act that was passed in March 2020, there are no required distributions for 2020 from IRAs — whether inherited or not.

Death in 2020 or Later

If the IRA owner dies in 2020 or later, we first have to determine whether the beneficiary is an “eligible beneficiary.”

Eligible beneficiaries include:

  • the surviving spouse of the original account owner,
  • a minor child of the original account owner,
  • anybody who is disabled or chronically-ill (per the definition found in IRC 7702B(c)(2)), or
  • any designated beneficiary who is not more than 10 years younger than the original account owner.

If the beneficiary is an eligible beneficiary, then the old rules apply (see below).

If the beneficiary is not an eligible beneficiary, the new rule applies. And the new rule simply says that the account must be completely distributed within 10 years of the original owner’s death. The distributions do not, however, have to occur evenly over those 10 years. (For instance, if you wanted to do so, you could take no distributions for the first 9 years, then distribute everything in year 10.)

Deaths in 2019 or Earlier, As Well as Eligible Beneficiaries

The “old rules” discussed in the remainder of this article apply in situations in which either:

  • The IRA owner died in 2019 or earlier, or
  • The beneficiary is an “eligible beneficiary” as described above, and therefore able to use the (more favorable) old rules.

Under the “old rules,” there are still actually two sets of rules: one set of rules that applies if the deceased owner was your spouse, and another set for any other designated beneficiary. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.

Inherited IRA: Spouse Beneficiary

As a spouse beneficiary, you have two primary options:

  1. Do a spousal rollover — rolling the account into your own IRA, or
  2. Continue to own the account as a beneficiary.

Note: there’s no deadline on a spousal rollover. Should you want to, you can own the account as a spousal beneficiary for several years, then elect to do a spousal rollover.

If you do a spousal rollover, from that point forward it’s just a normal IRA (i.e., it’s just like any other IRA that was yours to begin with), so all the normal IRA rules apply, whether Roth or traditional.

If you continue to own the account as a spousal beneficiary, the rules will be similar to normal IRA rules, but with a few important exceptions.

No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)

Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).

Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he/she died, but he/she had not yet taken it, you’re required to take it for him/her, calculated in the same way it would be if he/she were still alive.)

Your RMD from the account will be calculated each year based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B.**

Inherited IRA: Non-Spouse Beneficiary

When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.

No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)

Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)

Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a required minimum distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)

The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590-B. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**

For example, imagine that your father passed away in 2018 at age 65, leaving you his entire IRA. For 2018 (the year of death), you have no RMD. On your birthday in 2019, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2019 would have been equal to the account balance as of 12/31/2018, divided by 53.3.

For 2020, if it weren’t for the CARES Act eliminating RMDs for 2020, your RMD would have been equal to the account balance at the end of 2019, divided by 52.3. (But because of the CARES Act, the RMD for 2020 would be zero.) In 2021, the RMD will be the 12/31/2020 balance, divided by 51.3.

Important exception: if you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.

Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.

If the original account owner died in 2020 or later, the new rule is that the successor beneficiary (regardless of who it is) will have to distribute the remainder of the account within 10 years of the death of the original beneficiary. (Note: within 10 years of the death of the original beneficiary, not 10 years of the death of the original owner.)

If the original account owner died in 2019 or prior, successor beneficiaries are subject to the same “old rules” as described above for the original beneficiary, with one exception: the successor beneficiary must continue to take distributions each year as if they were the original beneficiary.

By way of illustration, in the example above (with your father, the original owner, dying in 2018) if you were to then die in 2021, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2021 distribution, she’d have to take it. Her 2022 distribution would be exactly what yours would have been if you were still alive: the 12/31/2021 balance, divided by 50.3.

Tips for Non-Spouse Beneficiaries

  1. When you retitle the account, be sure to include both your name and the name of the original owner.
  2. Name new beneficiaries for the account ASAP.
  3. If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.

Inherited IRA: Multiple Beneficiaries

If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.

However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:

  • A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
  • Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.

Note: if the original owner dies in 2020 or later and at least one beneficiary is a “non-eligible beneficiary” (per the definition from the beginning in this article), then the whole account will have to be distributed within 10 years, unless the IRA agreement has a provision that immediately divides the IRA into separate IRAs for each beneficiary.

To split an inherited IRA into separate inherited IRAs:

  1. Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
  2. Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
  3. Change the SSN on each account to be that of the applicable beneficiary.

A Few Last Words

When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes can be very costly.

Also, should you elect to get help with the decision — a good idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.

**If a) the inherited IRA is a traditional IRA, b) you are older than the deceased IRA owner, and c) the deceased IRA owner had reached his “required beginning date” by the time he died, your RMD could actually be smaller than the amount calculated above, as you can calculate it based on what would be the deceased owner’s remaining life expectancy (from the “Single Life” table) using the owner’s age as of his birthday in the year of death (and reducing by one for each following year).

What Counts as Compensation (Earnings) for IRA Contributions?

I’ve received a few questions recently about what types of income count as “compensation” for IRA contribution purposes.

The definition of compensation is important because your IRA contributions for a given tax year are limited to the amount of your “compensation that is includible in your gross income” for the year. (If you are married, you and your spouse’s combined IRA contributions are limited to your combined such compensation.)

There are two key points here:

  1. The income in question must be something that is included in your gross income (e.g., foreign earned income that is excluded would not count), and
  2. It has to be income that counts as compensation.

So what counts as compensation?

Treasury Regulation 1.219-1(c) provides the following definition:

For purposes of this section, the term compensation means wages, salaries, professional fees, or other amounts derived from or received for personal service actually rendered (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses) and includes earned income, as defined in section 401 (c) (2), but does not include amounts derived from or received as earnings or profits from property (including, but not limited to, interest and dividends) or amounts not includible in gross income.

In plain language, that means that the following count as compensation:

  • Wages/salary,
  • Commissions,
  • Net earnings from self-employment,
  • Scholarship or fellowship income if the income is reported in Box 1 of Form W-2 (i.e., reported as wages),
  • Taxable alimony and separate maintenance (i.e., for divorces that became finalized prior to 2019), and
  • Nontaxable combat pay.

And compensation does not include:

  • Interest or dividend income,
  • Other earnings or profits derived from property (e.g., rental income),
  • Social Security benefits,
  • Pension or annuity income,
  • Deferred compensation,
  • Income from a partnership for which you don’t provide services that are a material income-producing factor, and
  • Any income (other than combat pay) that isn’t included in your gross income.

For tax years 2020 and beyond, the SECURE Act made an additional change relating to fellowship/stipend income. Specifically, compensation will also include “any amount which is included in the individual’s gross income and paid to the individual to aid the individual in the pursuit of graduate or postdoctoral study.”

Compensation Reduced by Pre-Tax 401(k) Contributions

One noteworthy point here is that, when it comes to wages, it’s the amount that shows up in Box 1 of your Form W-2 that matters. And this amount in question is reduced by any pre-tax (“traditional”) 401(k) contributions that you make at work. Point being, if your earnings are low enough, pre-tax 401(k) contributions at work could reduce the amount you’re allowed to contribute to an IRA for the year. Roth 401(k) contributions do not, however, reduce the amount in Box 1. So Roth 401(k) contributions would not reduce the amount you can contribute to an IRA.

Should I Roll My 401k into My New 401k or into an IRA?

A reader writes in, asking

“If I’m leaving my employer to take a new position, how should I determine whether to roll my current 401K into the new 401K or into an IRA?”

If you have already decided that you do want to roll your 401(k) somewhere else (e.g., because the old 401(k) has very expensive investment options), there are a handful of factors to consider. Not coincidentally, those factors are very similar to the factors considered when determining whether to roll a 401(k) over to an IRA in the first place.

Where Do You Have Better Investment Options?

If your new employer-sponsored plan has investment options that are better than what you’d have access to in a regular IRA, rolling your money into the new employer plan can be advantageous. Common examples would be people starting a job with the federal government (and who would therefore have access to the super-low-cost Thrift Savings Plan) or people whose new employer plan includes something like Vanguard Institutional share classes (i.e., Vanguard funds with lower costs than Admiral shares).

When Do You Plan to Retire?

If you separate from service with a given employer in or after the year in which you reach age 55, you can take penalty-free distributions from that employer’s 401(k) plan, whereas normally you have to wait until age 59.5 (unless you meet one of a few other exceptions).

As such, if you plan to retire in or after the year you turn 55 but before you turn 59.5, having more money in your final employer’s 401(k) may make it easier to meet your living expenses without having to find another exception to the 10% penalty. If you expect to be in such a scenario (e.g., because you’re age 50 right now when you’re switching jobs and you expect to retire 5-6 years from now), rolling your current 401(k) into your new 401(k) could be advantageous.

Are You Planning Roth Conversions?

If you are planning Roth conversions in your traditional IRA (or you have already done one this year) and your traditional IRA includes amounts from nondeductible contributions (e.g., because you’re executing a “backdoor Roth” strategy), then it can be wise to avoid rolling 401(k) money into a traditional IRA, because doing so would increase the amount of tax you’d have to pay on your conversions.

This wouldn’t necessarily mean, however, that you should roll your old 401(k) into the new 401(k). It might just mean that you should temporarily leave your old 401(k) where it is, with the plan to roll it into an IRA in some future year (e.g., the year after the year in which you do your last Roth conversion).

Expecting a Lawsuit?

I don’t write about this often, as it’s distinctly outside my area of expertise, but in some cases money in a 401(k) may have better protection from creditors than money in an IRA. So if you are expecting to be sued — or you work in a field where lawsuits are common — you should speak with a local attorney to discuss whether your money would be safer in a 401(k) than in an IRA.

Should I Stop Contributing to Retirement Accounts if I’m Planning on Early Retirement?

A reader writes in, asking:

“The conventional wisdom of retirement saving is to put as much money as possible into retirement accounts rather than normal brokerage accounts. I’ve done this for years, but I’m considering if I should stop contributing to my 401 and IRA because I am planning on an early retirement. My employer does not offer a match, so I wouldn’t be missing anything there.”

As with any tax-planning question, the answer is, “it depends.” In most cases, however, it makes sense to continue contributing to retirement accounts, even if you’re planning on retiring early.

For people (unlike our reader) for whom a 401(k) match is available, it definitely makes sense to get that match, regardless of planned retirement age.

Accessing Your Money

A concern that many people have if they’re planning to retire prior to age 59.5, is that they will have to pay a 10% penalty to get to their money. But the 10% penalty can typically be avoided with sufficient planning.

For instance, any money that you contributed to a Roth IRA (as opposed to earnings in the account or amounts in the account as a result of Roth conversions) can be taken out of the account at any time, free from tax or penalty.

And if you retire in (or after) the year in which you turn age 55, money in your 401(k) with your most recent employer will be available penalty-free. (For public safety government employees, it’s age 50 rather than 55.)

Then there’s a whole list of other exceptions to the 10% penalty that you might be able to take advantage of. Most importantly, you can take money out of a retirement account penalty-free if you do it as part of a “series of substantially equal periodic payments” that lasts 5 years or until you’ve reached age 59.5, whichever comes later. (This rule is available to anybody, so it can be super helpful as part of an early retirement plan. It is, however, complicated. So it’s important to do your research and, most likely, work with a tax professional.)

Finally, it’s worth noting that if you’re planning to retire very early, it’s likely that you’re going to be saving more per year than you can contribute to retirement accounts anyway. So you’re going to have some savings in taxable accounts even if you continue contributing as much as possible to retirement accounts.

Other Considerations

All of the above deals with whether you would have tax-free/penalty-free access to the money. But that’s only part of the analysis.

Once you have a good idea of whether the penalty will be applicable or not for the money in question, you would want to consider the following factors:

  • What is my current marginal tax rate?* (That is, how much value would you get from having a smaller taxable income this year as a result of contributing to a tax-deferred account?)
  • What will be my marginal tax rate (including 10% penalty, if applicable) when this money comes out of the account?
  • How much value would I get as a result of having the money in a retirement account? (That is, how valuable is the faster rate of growth that will occur as a result of not having to pay tax each year on interest/dividends?**)

*As always, “marginal tax rate” might be something other than just your tax bracket. For instance, your current marginal tax rate could be greater than your tax bracket if making a contribution to a tax-deferred account would allow you to claim the retirement savings contribution credit — or if it reduces your adjusted gross income to a level such that you can claim some other deduction/credit.

**The longer your money is expected to be in the account, the more valuable this faster rate of growth. Also, a key point is that if you’re in the 15% tax bracket or below — and you expect to stay there — qualified dividends and long-term capital gains are already tax-free in a normal taxable account. So having the money in a retirement account won’t provide nearly the same benefit as it would for somebody in a higher tax bracket.

Is It a Good Idea to Front-load 401(k) Contributions?

A reader writes in, asking:

“On dollar cost averaging, if you can frontload your entire max 401(k) contribution to the first half of the year, is there a reason not to? It seems like you’d give it more time to do its compound interest thing, and in general the market trend is up over time.”

In many cases, yes, it makes great sense to max out your 401(k) contributions as early in the year as possible, in order to get the money invested as early as possible. (Ditto with IRA contributions, for the same reason.)

In some cases, however, doing so can cause you to miss out on part of the employer matching contribution — if your employer offers one. It all depends on how the plan actually calculates the matching contribution each pay period.

For example, consider three different hypothetical 401(k) plans, each of which could be described as having a “dollar for dollar match, up to 4% of compensation.”

With Plan A, the employer matches every dollar you’ve put in, until you hit 4% of your annual compensation. So by front-loading, you get your maximum match, and you get it early in the year. Great!

With Plan B, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you have contributed an equal amount already in the year. So by front-loading you get your own money invested as soon as possible, and you still get the maximum match, but it doesn’t speed up the rate at which you get the matching contribution (i.e., you still only get 4% per pay period). Still, front-loading is probably a good idea, if you can do it.

With Plan C, each pay period, the employer will contribute up to 4% of your compensation for that pay period, as long as you contributed an equal amount in that pay period. In this case, if you front-load your contribution, you actually end up missing out on part of the match. For example, if you max out the 401(k) in the first quarter of the year, you would not get any matching contribution in the final three quarters, because you didn’t contribute anything in those pay periods. In other words, you’d miss out on 3/4 of your total possible maximum match.

So, in short, it’s important to have a discussion with the plan administrator about how exactly the matching contribution is calculated (if there is one). Or, if you really want to be sure, get a hold of the plan document and read for yourself how the matching contribution is calculated.

Should I Put Stocks in My Roth IRA and Bonds in My Traditional IRA?

A reader writes in, asking:

“If I have a Roth IRA and traditional IRA, is it better to put my stock funds in the Roth and the bond funds in the traditional IRA? That seems preferable, because as long as stocks do earn more than bonds it would leave me with more money down the road because the Roth is tax-free.”

Yes, it is often preferable to put your investments with higher expected returns in Roth accounts rather than tax-deferred accounts — but not for the reason you mentioned.

Loading up your Roth accounts (as opposed to tax-deferred accounts) with investments with higher expected returns will (assuming “expectations” pan out) leave you with more money to spend after taxes than if you had taken a different approach. But that’s simply because you took on more risk.

By putting your high-risk investments in a Roth, you expose yourself to more risk than you would if you had an equal allocation in both tax-deferred and Roth. The reason for this is that you feel the full effect of fluctuations in the balance of your Roth IRA, whereas you only feel a portion of the effect of fluctuations in the balance of tax-deferred accounts.

For example, imagine that you expect to have a marginal tax rate of 25% during retirement. If your Roth IRA’s value changes by $20,000, that changes the amount of money you have available to spend by $20,000. In contrast, if your traditional IRA’s value changes by $20,000, the amount of money you have available to spend only changes by $15,000 (because $20,000 in the traditional IRA is only worth $15,000 to you, given a 25% marginal tax rate).

In other words, using your Roth IRA entirely for high-risk investments is very similar to just bumping up your allocation to high-risk investments in the first place — it will likely result in more money in the end, but at the cost of higher risk.

Now, having said that, it does typically make sense to prefer to use the Roth for investments with higher expected returns.

Why?

Because Roth IRAs Have No RMDs

As long as a Roth IRA is owned by its original owner (as opposed to being owned by a beneficiary after the death of the original owner), RMDs do not have to be taken from the account at any point.

So, in that sense, you would prefer to have a Roth IRA of a given size rather than a proportionally-larger traditional IRA, because the Roth gives you better control over your money.

For example, you would rather have $75,000 in a Roth IRA than $100,000 in a traditional IRA with a 25% marginal tax rate, despite the fact that the two amounts are functionally equivalent in terms of how much they leave you with after taxes.

For that reason, it does typically make sense to use your Roth accounts for the investments with the highest expected return. But you should be aware that in doing so, you increase your overall risk, so you may want to compensate by reducing risk slightly in some other manner.

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