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What the SECURE Act, New IRS Regs Mean for Spouses Who Inherit IRAs

Published on: May 26 2022

Surviving spouses need to know the special options and opportunities they have when inheriting IRAs, 401(k)s and similar retirement accounts so they’ll maxi- mize the after-tax value of the accounts. Retirement accounts often are among the most valuable assets in- herited.

Making the wrong decision with an inherited retirement account can trigger thousands of dollars in extra taxes. The rules for inherited IRAs and other retirement accounts were up- ended by the Setting Every Commu- nity Up for Retirement Enhancement (SECURE) Act, enacted in 2019, and by the IRS proposed regulations un- der the act issued this past February.

Last month, I reviewed the rules for non-spouses. This month, we focus on the rules for surviving spouses. The good news is the rules for surviving spouses weren’t changed much by the new law and regula- tions. Surviving spouses continue to have more options with inherited IRAs than other beneficiaries. But these options create the potential for pitfalls.

One option for the surviving spouse is to distribute all the inher- ited IRA’s assets within five years after the other spouse passed away. The IRA can be distributed on any schedule within those five years. All the distributions will be included in gross income and taxed in the same way they would have been to the original owner. This usually is the least attractive option from a tax planning perspec- tive.

But it’s one to be considered when there’s a need for the cash. Note that regardless of the age of the inheriting spouse, the 10% penalty on distributions made before age 59½ doesn’t apply to retirement account distributions that follow the death of the original owner. Only income taxes will be due.

The second option is to treat the account the same as one inherited by a non-spouse. This is the option that’s changed the most under the SECURE Act and IRS regs. In gener- al, the surviving spouse would have to fully distribute the entire IRA within 10 years after inheriting it. In addition, if the deceased spouse already had reached the beginning age for required minimum distribu- tions (RMDs), the surviving spouse must take annual RMDs during years one through nine. The details of the 10-year rule and how it applies to non-spouses were discussed last month.

Surviving spouses younger than 59½ shouldn’t reject the second option right away, for reasons I explain below. The third option, and one that’s unique for surviving spouses, is the spousal rollover, or fresh start, IRA. The surviving spouse can use this option for his or her share of an IRA even when there are other primary beneficiaries.

The surviving spouse rolls over the assets to his or her own IRA. The roll- over can be done by the IRA custodi- an, or the surviving spouse can take a distribution and deposit that amount into his or her own IRA within 60 days.

The spousal IRA can be a new IRA set up to receive the inheritance or an existing IRA of the surviving spouse. The assets also can be moved tax-free to any other qualified retire- ment plan account of the surviving spouse, such as a 401(k) account. Once a spousal IRA is created, it is treated as though it always were the surviving spouse’s IRA.

No refer- ence is made again to the previous IRA, and it is not considered an inherited IRA. The surviving spouse names new beneficiaries. The RMD schedule is determined solely by the surviving spouse’s age. That’s why it’s called a fresh start IRA. Once execut- ed, a spousal rollover is irrevocable.

A fourth option is very similar to the third option. The surviving spouse simply treats the inherited IRA as his or her own IRA. This has the same effects as the spousal IRA, but it rarely is done this way.

Usually, the spousal rollover is used to avoid any misunderstanding about the surviving spouse’s intentions. The best choice usually depends on the surviving spouse’s age.

Remember that after a spousal rollover, the IRA is treated without reference to the previous IRA. That means when the surviving spouse is younger than 59½, the 10% penal- ty for early distributions applies to distributions from a spousal rollover IRA, unless the surviving spouse qualifies for one of the exceptions to the penalty. But the 10% early distribution penalty doesn’t apply to distributions from an inherited IRA.

If the sur- viving spouse is less than age 59½ and might need to take distributions before reaching that age, then the non-spouse inherited IRA treatment likely is the best option. When the surviving spouse is older than age 59½, then the spousal roll- over usually is the preferred option.

That’s because the spousal rollover can be executed at any time and the decision to treat the IRA as a non- spouse inherited IRA isn’t irrevocable. That provides good options for a relatively young surviving spouse. The surviving spouse first can treat the IRA as a non-spouse inherited IRA.

Then, after reaching age 59½ (or at any other time), a spousal rollover can be executed with the remaining IRA balance. In some circumstances, this strategy is less attractive after the SECURE Act.

Suppose the surviving spouse is substantially younger than the deceased spouse and the deceased spouse already reached the begin- ning date for RMDs. In that case, when the surviving spouse treats the IRA as a non-spouse inherited IRA, annual RMDs must be taken in years one through nine and the entire IRA must be distributed by the end of year 10. If there’s still money in the IRA when the surviving spouse pass- es age 59½, then it can be converted to a spousal IRA.

Whether this is an attractive strate- gy depends on how likely the spouse is to need distributions before age 59½. If distributions are likely to be needed, then non-spousal IRA treat- ment probably is desirable to avoid the 10% early distribution penalty. The effects on the next generation of beneficiaries also should be con- sidered.

When the surviving spouse choos- es the non-spouse inherited IRA option and passes away while there’s still money in the IRA, then the next generation of beneficiaries must con- tinue the same distribution sched- ule the surviving spouse had. That means the IRA must be fully distrib- uted by the end of the 10th year after the surviving spouse inherited it.

The beneficiaries also might have to take annual RMDs if the surviving spouse was taking them. But when the spousal rollover was used, the rules for successor benefi- ciaries are different. The beneficiaries must fully distribute the IRA by the end of the 10th year after the surviv- ing spouse passes away.

In addition, they’ll have to take annual RMDs if the surviving spouse had reached the required beginning date (age 72) before passing away. There’s one other angle to consider. I regularly advise people not to name their estates as IRA beneficiaries or not to fail to name an IRA benefi- ciary.

That’s because the potential for deferral beyond five years is lost when an entity other than a natural person is the beneficiary. But there’s a narrow exception when the sur- viving spouse is the sole primary beneficiary of the estate and the sole beneficiary of the IRA proceeds that pass through the estate.

In that case, the surviving spouse still can execute a spousal rollover within 60 days after proceeds are re- ceived from the IRA, but the surviv- ing spouse doesn’t have the option of treating the IRA as an inherited IRA. (IRS Private Letter Ruling 201618011) That’s a narrow exception and not one that you should rely on.

If you want your spouse to inherit your IRA and have the widest range of options, you should name him or her as the sole primary beneficiary. Then, be sure your spouse will be informed of the options for handling the IRA and how to choose the better option. These rules apply whether a tradi- tional IRA or Roth IRA is inherited. There’s one other point to note. The same rules generally apply to both IRAs and employer retirement plans, such as 401(k)s.

But employers are allowed to place additional limits on beneficiaries, whether spouses or non-spouses. For example, some em- ployer plans require the full account to be distributed or rolled over to an IRA within a short period after the owner passes away. If you’ll leave money in a 401(k) or other employer plan, be sure to check the rules the employer has for beneficiaries and make sure the benefi- ciaries know them.

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