What Happens to an Inherited IRA When Its Beneficiary Dies?

An inherited Individual Retirement Account (IRA) is a financial asset passed from a deceased owner to a designated beneficiary. When this initial beneficiary also passes away, the account’s future becomes complex. Navigating these circumstances requires a clear understanding of who is entitled to the funds and the rules governing distribution. This process involves identifying the next in line to inherit, adhering to distribution timelines, and managing tax obligations.

Identifying Successor Beneficiaries

A successor beneficiary is the individual or entity designated to receive assets of an inherited IRA after the death of the initial beneficiary. This designation follows a hierarchy established by the original IRA owner, the initial beneficiary, or default provisions of the IRA custodian agreement. The most straightforward method for identifying a successor beneficiary is through the initial beneficiary’s own beneficiary designation form for the inherited IRA, if completed. This form allows the initial beneficiary to name contingent beneficiaries.

Alternatively, the original IRA owner might have named contingent beneficiaries to inherit the IRA upon the death of the primary beneficiary. If neither of these designations exists, the initial beneficiary’s will or living trust might stipulate who receives the inherited IRA. Custodial agreements often contain default provisions that dictate how the inherited IRA is distributed if no successor beneficiary is named. These provisions commonly direct the assets to the initial beneficiary’s estate.

When an inherited IRA passes to the initial beneficiary’s estate, the assets become subject to the probate process, which is time-consuming and costly. Probate is the legal process of validating a will and distributing assets under court supervision. This scenario can also lead to different distribution rules and tax treatments than if an individual or entity were named as a successor beneficiary. Understanding these layers of designation and default provisions is important in determining the rightful recipients of the inherited IRA.

Understanding Distribution Rules for Successor Beneficiaries

The rules governing distributions from an inherited IRA to a successor beneficiary are dictated by the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which altered previous regulations. For most successor beneficiaries, the primary rule is the “10-Year Rule.” This rule requires the entire inherited IRA balance to be distributed by the end of the calendar year containing the 10th anniversary of the initial beneficiary’s death. For example, if the initial beneficiary died in 2025, the successor beneficiary must fully distribute the IRA by December 31, 2035.

This 10-year period applies regardless of the successor beneficiary’s age or relationship to the initial beneficiary, provided they are not an “Eligible Designated Beneficiary” (EDB). The SECURE Act introduced a distinction for beneficiaries allowed more flexible distribution options. EDBs are permitted to stretch distributions over their life expectancy, an advantage over the 10-year rule.

There are categories of individuals who qualify as Eligible Designated Beneficiaries. These include the surviving spouse of the original IRA owner, disabled individuals, chronically ill individuals, and individuals not more than 10 years younger than the original IRA owner. If the initial beneficiary was the original owner’s spouse and treated the inherited IRA as their own, their successor beneficiary would generally fall under the 10-year rule, unless they themselves qualify as an EDB in relation to the deceased spouse.

Minor children of the original account owner qualify as EDBs, with a nuance. While they can take distributions over their life expectancy until they reach the age of majority, the 10-year rule then begins to apply once they attain that age, typically 18 or 21 depending on state law. This means the remaining balance must be distributed within 10 years from the date the child reaches the age of majority.

If the successor beneficiary is an individual not more than 10 years younger than the original account owner, they can utilize the life expectancy distribution method. This provision applies to siblings or close friends of the original owner who are of a similar age. The determination of EDB status is made at the time of the initial beneficiary’s death.

When an inherited IRA passes to a non-person entity, such as an estate or a charity, different distribution rules apply. If the inherited IRA passes to the initial beneficiary’s estate, the 10-year rule applies, with the estate distributing the funds within 10 years of the initial beneficiary’s death. If a trust is named as a successor beneficiary, the distribution rules depend on whether the trust qualifies as a “look-through” trust. A look-through trust must meet requirements, including being irrevocable, having identifiable beneficiaries, and providing documentation to the IRA custodian.

If the trust qualifies as a look-through trust, the distribution period is based on the life expectancy of the oldest beneficiary of the trust, if that beneficiary qualifies as an EDB. If the trust does not qualify as a look-through trust, or if the beneficiary is a charity, the 10-year rule applies. The applicable distribution rules are complex and depend on the death dates of both the original IRA owner and the initial beneficiary. For instance, if the original owner died before 2020, pre-SECURE Act rules might apply to the inherited IRA for the initial beneficiary, but the successor beneficiary would fall under the SECURE Act rules.

Tax Implications for Successor Beneficiaries

Distributions received from an inherited IRA by a successor beneficiary are taxable as ordinary income when received. This means the money is added to the successor beneficiary’s gross income and taxed at their marginal income tax rate. The character of the distribution, whether from a traditional or Roth IRA, remains the same. For example, distributions from an inherited traditional IRA are taxable, while qualified distributions from an inherited Roth IRA are tax-free.

The 10% early withdrawal penalty, which typically applies to IRA distributions taken before age 59½, does not apply to distributions from an inherited IRA. This exemption applies, regardless of the successor beneficiary’s age when they receive the funds. While the penalty is waived, the distributions remain subject to regular income tax.

Regarding estate taxes, the federal estate tax exemption is high, currently set at $13.61 million per individual for 2024. This means most inherited IRAs will not be subject to federal estate tax upon the death of the initial beneficiary. However, some states impose their own estate or inheritance taxes, which apply at lower thresholds. Successor beneficiaries should consult state tax laws to determine if state estate or inheritance taxes apply to the inherited IRA.

The concept of “basis” in an inherited IRA is important. For most inherited traditional IRAs, the basis is considered zero because contributions were tax-deductible, and earnings grew tax-deferred. This means any distribution is taxable as ordinary income. In contrast, for an inherited Roth IRA, the original owner’s contributions were after-tax, establishing a basis, and qualified distributions are tax-free. Understanding the type of IRA and its original tax treatment is important for successor beneficiaries.

Administrative Steps and Considerations

When an initial beneficiary of an inherited IRA passes away, administrative steps are necessary to transfer the account to successor beneficiaries. The immediate action is to notify the IRA custodian of the initial beneficiary’s death. This notification initiates the process for the custodian to freeze the account and begin the paperwork for transfer.

Successor beneficiaries, or their legal representatives, will need to provide documentation to the IRA custodian. This includes a certified copy of the initial beneficiary’s death certificate, along with proof of identity (e.g., driver’s license or passport). If the successor beneficiary is designated through a will or trust, legal documents (e.g., will, trust agreement, letters testamentary) may be required. The custodian will use these documents to verify the successor beneficiary’s entitlement to the assets.

Upon verification, the successor beneficiary will need to establish a new inherited IRA account in their name, titled to reflect its inherited nature. The proper titling is in the format of “John Doe, as Beneficiary of Jane Smith, Deceased, who was Beneficiary of Original Owner, Deceased.” This titling is important for tax purposes and to ensure the account is recognized as an inherited IRA, subject to its distribution rules. Failure to title the account correctly could inadvertently lead to the account being treated as the successor beneficiary’s own IRA, triggering tax liabilities or penalties.

Adhering to distribution deadlines is important to avoid penalties. For most successor beneficiaries, this means ensuring the inherited IRA balance is distributed by the end of the 10th year following the initial beneficiary’s death. Missing this deadline can result in a penalty of 25% of the amount that should have been distributed, though this can be reduced to 10% if corrected promptly. Understanding and tracking these deadlines is a significant responsibility for successor beneficiaries.

Given the complexities of identifying successor beneficiaries, navigating distribution rules, and managing tax implications, seeking professional guidance is beneficial. A qualified financial advisor or tax professional can provide tailored advice, ensure compliance with IRS regulations and assist with administrative steps. This professional assistance can help successor beneficiaries make informed decisions and avoid costly errors related to their inherited IRA.

Citations

H.R.1865 – Setting Every Community Up for Retirement Enhancement Act of 2019. Congress.gov.
Inherited IRAs: What You Need To Know. IRS.gov.
IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs). IRS.gov.
Retirement Plans FAQs regarding Waivers of the 10% Additional Tax on Early Distributions. IRS.gov.
Estate Tax. IRS.gov.
Retirement Plan and IRA Required Minimum Distributions FAQs. IRS.gov.