Most people think of IRAs as savings vehicles for retirement. However, they are also a good means of handing assets down to non-spousal beneficiaries, i.e., children and grandchildren.
The ability of an inherited IRA to grow on a tax-deferred basis over an extended period of time, was one reason why this kind of account has been used to pass wealth to non-spousal beneficiaries. However, in 2007 the rules changed, and as a result, non-spousal beneficiaries of 401(k) accounts and similar defined contribution retirement plans can enjoy the same benefits as the inherited IRAs.
Investopedia’s article, “Inherited IRA and 401(k) Rules Explained,” says spousal beneficiaries of an IRA have the option of taking the account and managing it, as if it was their own. This includes the calculation of required minimum distributions (RMDs). For non-spousal beneficiaries, an inherited IRA account can give them a few options, including the ability to stretch the IRA over time by letting it continue to grow tax-deferred.
IRA account holders who want to leave their accounts to non-spousal beneficiaries should enlist the help of an estate planning attorney who understands the complex rules surrounding these accounts. The account beneficiaries must be careful to ensure they don’t inadvertently trigger a taxable event.
The beneficiaries of an inherited IRA can open an inherited IRA account, taking a distribution (which will be taxable), or disclaiming all or part of the inheritance (causing the funds to pass to other eligible beneficiaries). Traditional IRAs, Roth IRAs, and SEP IRAs can be left to non-spousal beneficiaries in this way. A 2015 rule change says the creditor protection previously afforded an inherited IRA was ruled void by the U.S. Supreme Court. Inherited IRA accounts can’t be commingled with your other IRA accounts, but the beneficiary can name their own beneficiaries upon their death.
The rules around inherited IRAs and 401(k)s are complex and costly mistakes are made frequently by financial institutions, plan sponsors, beneficiaries and custodians. Be extremely careful when conducting any kind of transactions concerning these accounts.
Reference: Investopedia (December 18, 2017) “Inherited IRA and 401(k) Rules Explained”