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"Inherited IRA" written on Post-It noteThanks to a law that took effect in 2020, if you inherit a traditional individual retirement account (IRA) you may have to take all the account’s distributions within 10 years. The exception is if you qualify as an eligible designated beneficiary, in which case you can portion out distributions over your expected lifespan. That added flexibility can potentially save on income taxes and let your retirement funds last longer. How to handle tax-advantaged accounts in retirement can be challenging; that’s why it’s wise to consult a financial advisor so you can maximize your assets.

Eligible Designated Beneficiary, Defined

The Setting Every Community Up for Retirement Enhancement (SECURE) Act signed into law in December 2019 made a number of changes to rules on retirement withdrawals. One ended the longstanding rule that allowed most people who inherited IRAs to take withdrawals at a rate calculated to empty the account over their expected lifespan. The SECURE Act allows some people, whom it designated as eligible designated beneficiaries, to continue the previous practice, however.

The law also created two other categories of beneficiaries. Designated beneficiaries are beneficiaries who weren’t married to the deceased IRA owner and don’t otherwise meet the qualifications for eligible designated beneficiaries. Starting in 2020, designated beneficiaries had to take all the assets from inherited retirement accounts within 10 years. Previously, they’d been able to use the life expectancy distribution schedule.

The third new class of beneficiaries, non-designated beneficiaries, are trusts, estates, charities and other organizations that don’t have a life expectancy as a human beneficiary would. They have to follow the same 10-year distribution rules as a designated beneficiary.

As of mid-2021 the Internal Revenue Service had yet to clarify exactly how it will handle changes required by the SECURE Act. Originally, it appeared eligible designated beneficiaries would be able to choose the 10-year distribution plan. However, the IRS said in June 2021  eligible designated beneficiaries could only use the life expectancy approach. More changes may occur as the IRS develops a final rule.

Kinds of Eligible Designated Beneficiaries

Asian woman studies her inherited IRA

The SECURE Act recognizes five types of eligible designated beneficiaries. Lawmakers recognized that because of their special situations, these people might require long-lasting support from inherited IRAs. So, the law makes them exceptions to the rule requiring distribution of inherited IRA assets within 10 years. These are the five categories of eligible designated beneficiaries and special rules applying to each:

Surviving spouse – A spouse who inherits an IRA from a deceased partner can still choose to roll the IRA into his or her own IRA. Then the surviving spouse can start taking normal distributions at age 59.5, or wait until age 72, when required minimum distributions (RMDs) based on their expected lifespan become mandatory. The surviving spouse can elect to roll the inherited IRA into his or her own retirement account at any time.

Disabled or chronically ill – A beneficiary who is disabled or chronically ill can also choose to take distributions over his or her lifespan instead of emptying the account within 10 years. Disabled and chronically ill people have to meet the IRS definitions of these conditions in order to be considered eligible designated beneficiaries.

A non-spouse less than 10 years younger – If the beneficiary is not a surviving spouse and is not more than 10 years younger than the deceased owner of the IRA, then the beneficiary uses the life expectancy distribution plan.

Minor child – A child of the original IRA owner who is under 18 can at first take the distributions using the life expectancy standard. However, when he or she reaches the age of majority, then the 10-year rule becomes effective. This means that all the assets of the IRA will be distributed by the time the beneficiary is age 28.

Some trusts – A trust set up to benefit someone who is an eligible designated beneficiary as a result of being disabled or chronically ill is itself considered an eligible designated beneficiary. Trusts set up to benefit other beneficiaries have to confirm to special rules to be considered eligible designated beneficiaries.

Penalties and Strategies

IRA beneficiaries who don’t take the required withdrawals can expose themselves to significant costs. The IRS can levy an excess accumulation penalty tax of 50% on IRA assets that are supposed to have been distributed by the end of the 10-year period but weren’t.

The new law is prompting development of new strategies for managing the distribution of retirement assets. One approach is to designate eligible designated beneficiaries to inherit assets in retirement accounts so they can use the longer distribution period. Other assets outside tax-advantaged accounts would be directed to other beneficiaries.

Bottom LineFinancial advisor discusses a couple's inherited IRA

Eligible designated beneficiaries are people who inherited IRAs and, because of their special characteristics, don’t have to take out all the money from the IRA within 10 years of receiving it. Instead, they can stretch distributions over their expected lifespans, which can help them manage taxes. Eligible designated beneficiaries include surviving spouses, chronically ill or disabled individuals, offspring of the original IRA owner who are under age 18, non-spouses who are at least 10 years younger than the owner and some trusts set up to benefit eligible designated beneficiaries. All others who inherit IRAs must take regular distributions that empty the accounts within 10 years.

Tips on Estate Planning

  • Whether you are selecting beneficiaries of your own IRA or are an IRA beneficiary who may potentially be an eligible designated beneficiary, you need up-to-date knowledge of IRS regulations and the tax consequences. That’s where a financial advisor can be vital. Finding one doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
  • It’s not unusual to have both an IRA and a 401(k) to your name. In the end, utilizing both types of accounts can only improve your chances of reaching a comfortable retirement. Check out SmartAsset’s 401(k) calculator and guide to employer 401(k) matching.

Photo credit: ©iStock.com/designer491, ©iStock.com/PamelaJoeMcFarlane, ©iStock.com/FatCamera

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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