Ensuring that beneficiaries are listed on all retirement accounts, including IRAs, is important to avoid costly mistakes. Beneficiary designations also help ensure that the account owner’s wishes are honored.
When making the designations it is also important to note that there are fundamental differences among types of beneficiaries, specifically spousal compared with non-spousal. The tax code gives preference to spousal beneficiaries with more choices and potentially more advantageous tax treatment of required distributions compared with non-spouse beneficiaries.
Spouses may choose between two courses of action
Spouses have the flexibility to make the IRA their own or remain as a beneficiary on the deceased spouse’s IRA.
Spouses are the only beneficiaries who can treat an inherited IRA as their own. This can be a benefit for several reasons:
- It may be easier to consolidate all IRAs into one account for management and recordkeeping purposes
- When the surviving spouse is younger than the deceased spouse. For example, If the deceased IRA owner already reached their required beginning date (RBD),* a rollover into a spousal IRA would allow the surviving spouse to postpone taking RMDs until their RBD
There may be instances where the spouse may benefit from remaining as the beneficiary of the inherited IRA instead of rolling the IRA into their own account:
- Surviving spouse is younger than 59½. Consider a surviving spouse who is younger than 59½ and may need to access IRA funds to meet expenses. In this case rolling over the deceased spouse’s IRA to the surviving spouse’s IRA could result in a 10% early withdrawal penalty if distributions occur. Instead, by remaining as a beneficiary of the deceased spouse’s IRA, a 10% early withdrawal penalty would not apply due to the death exception. The surviving spouse could always rollover the IRA into their own name at a later date. They may want to wait until they reach age 59½, when an early withdrawal penalty no longer applies, or for a time when they do not expect to take any distributions from the inherited IRA.
- Surviving spouse is older than the deceased spouse. Remaining as the beneficiary of the IRA may allow the surviving spouse to postpone taking RMDs until the decedent would have reached their required beginning date. Or, RMDs based on the deceased spouse may be lower than if based on the (older) age of the surviving spouse.
*Required beginning date (RBD) is generally April 1 of the year following the calendar year in which the account owner reaches age 73. For those born in 1960 or after the age is 75.
Managing inherited IRAs
Other advantages for spousal beneficiaries
Ability to “stretch” required minimum distributions (RMDs) based on remaining life expectancy
The SECURE Act introduced a new “10 year rule” requiring many heirs of retirement accounts and IRAs to draw down inherited accounts within a 10-year time period following the year the owner died. Spouses are not subject to this new rule but are considered “eligible designated beneficiaries” meaning they can calculate RMDs based on life expectancy factors from IRS tables. For example, a 60-year-old spousal beneficiary who is eligible to stretch required distributions based on remaining life expectancy would have roughly 25 years to draw down the inherited IRA. Most non-spouses who inherit an IRA must fully distribute the account within 10 years following the year the original account owner died. This may result in a greater tax burden since there are less years to spread the distributions from the IRA.
There are some exceptions for certain non-spouse beneficiaries who are eligible for RMDs based on their life expectancy. These include those who are disabled, chronically ill, not more than 10 years younger than the account owner, and a minor child of the account owner (until reaching age 21).
Different RMD calculation for spousal beneficiaries vs. non-spousal beneficiaries
Spousal beneficiaries can “recalculate” their RMDs each year based on the IRS life expectancy tables. Each year, the spouse can use the life expectancy factor from the IRS table to calculate the RMD. This is different from how non-spouse beneficiaries calculate RMDs. Non-spouses use the “subtract one” method. This means that for the first year’s distribution following the year the IRA owner died, the non-spouse beneficiary uses the life expectancy factor from the IRS table (single life, table 1) to calculate the RMD. For each subsequent year the non-spouse beneficiary does not refer to the IRS table but simply subtracts one from the initial figure to calculate the RMD. This will result in a larger RMD for a non-spouse vs. a spouse, all else being equal.
For more information on distributions from IRAs consult IRS publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).