For many people, a time will come when a parent, spouse, sibling or other beloved family member passes away and they will inherit IRA assets. Because the rules regarding inherited IRAs are not simple, mistakes are often made with inherited IRAs, whether they are inherited by spouses, children or others. In our experience in working with married couples, most of them name their spouse as the primary beneficiary of their IRA or other retirement accounts like their 401(k) or 403(b). Therefore, it is important for married couples to know how to apply the rules when a spouse inherits an IRA. Failing to understand these rules can cause a surviving spouse to end up paying higher taxes or penalties, and even possibly giving up some future tax-advantaged growth of the inherited IRA. In this blog, I will highlight the main options available for spousal beneficiaries, and some important considerations to review before making decisions.
Let’s begin with the basic options that a spousal beneficiary has available to them. The first option, which is very common and only available to spousal beneficiaries, is to roll over their deceased spouses’ IRA into their own IRA, also known as a spousal rollover. In this type of rollover, the funds are treated as always having been in the surviving spouse’s IRA and the decision is irrevocable once it is completed. It can’t be reversed if it is later determined that some other strategy would be better for the surviving spouse.
The next option available to surviving spouse’s as beneficiaries is to use an inherited IRA to receive the proceeds of their spouse’s IRA. This option is similar to the inherited IRA rollover option available to non-spouse beneficiaries. When considering this option, it is important for spousal beneficiaries under age 59 ½ to know that it allows them to take penalty free distributions from the IRA at any age and at any time.
Another infrequently used option is to treat the deceased spouse’s IRA as their own. This strategy is used infrequently because it basically has the same tax consequences as the spousal rollover option above.
The following are a few factors that need to be considered by a surviving spouse in making his or her decision: their own age, the age of their spouse, the need for income from the inherited IRA assets, among others. Because of the 10% penalty on withdrawals from IRAs before age 59 ½, the most beneficial strategy often depends on the age and income needs of the surviving spouse. A surviving spouse under age 59 ½ who elects to do the spousal rollover option will have to pay the additional 10% penalty on any distributions made before age 59 ½ because the IRA is treated as their own IRA. However, if that under age 59 ½ surviving spouse elects to do the inherited IRA option, the 10% early distribution penalty does not apply to the withdrawals. For surviving spouses under age 59 ½ who need to withdraw from the IRA, the inherited IRA likely is the best option. In addition, a spouse who begins by electing the inherited IRA option can later (usually after age 59 ½) execute a spousal rollover if that strategy would then become more beneficial.
When the surviving spouse is older than age 59½, then the spousal rollover may be the preferred option for a number of reasons. As noted above, once reaching 59 ½, the 10% penalty on early withdrawals no longer exists. In addition, depending on the circumstances, the spousal rollover option may allow for a longer delay in having to make required minimum distributions from the IRA to the surviving spouse. In some situations, the spousal rollover option may also offer improved tax-deferral options for the beneficiaries of the surviving spouse’s IRA.
In conclusion, this is a fairly short blog on a topic where the rules are complex and the best strategy to pursue is often dictated by the uniquely specific circumstances of the surviving spouse. My hope in writing this blog is to highlight some of the considerations to be made, and to encourage anyone who is the beneficiary of their spouse’s IRA to seek advice from their financial and tax advisors when deciding which rollover strategy is best. Please feel free to contact your Atlanta Financial advisor if you have any questions or if we can help you in any way with your IRA beneficiary strategies.