Understanding Inherited IRAs

Written by Carson Hamill CIM®, CRPC®, Associate Financial Advisor and Assistant Branch Manager & Dean Moro BComm, CIM®, Associate Financial Advisor

Inherited IRAs are very complex. Here, we will discuss what an inherited IRA is, how they differ for spouses and non-spouses, and some rules for distributions. As always, ensure you speak with a qualified tax professional if you are the beneficiary of an IRA, or assisting with the settlement of an estate that involves a U.S. retirement account.

• What Is an Inherited IRA
• Inherited IRA for Spouses
• Inherited IRA for Non-Spouses
• Distributions From Inherited IRAs and the SECURE Act
• Inherited by a non-spouse before 2020: “Stretch IRA”
• Inherited IRAs and Canadian Beneficiaries
• Case Study
• FAQ
• Summary

What Is an Inherited IRA

An inherited IRA is a retirement account initiated when you inherit a tax-advantaged retirement plan like an Individual Retirement Account (IRA) or a employer-sponsored retirement plan such as a 401(k) upon the death of the original owner. Basically, when the owner of an IRA or 401(k) dies, the account passes to their beneficiary, and the beneficiary can choose to roll it to an inherited IRA, rather than taking an immediate taxable distribution.

Most IRAs and employer-sponsored retirement plans can be transferred to an inherited IRA, including traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP IRAs, and 401(k) plans. The individual inheriting the IRA (the beneficiary) may be anyone, including a spouse, relative, or unrelated individual or entity (estate or trust). However, rules on how to handle an inherited IRA differ for spouses and non-spouses.

Inherited IRAs for Spouses

Spouses have a number of options available to them when it comes to inherited IRAs. They can roll the IRA, or a portion of the IRA, into their own existing IRA, which may be attractive to defer withdrawals until they turn 72. This must be done within 60 days of receiving the distribution as long as the distribution was not a Required Minimum Distribution (RMD).

Alternatively, spousal beneficiaries can set up a separate inherited IRA. Their decision will be based on the age of the original account holder and whether they were already receiving RMDs. If they were, then the beneficiary must continue receiving distributions but can select a new schedule based on their own life expectancy. If the original owner was not receiving distributions, the beneficiary has up to five years to begin withdrawing funds.

Inherited IRAs for Non-Spouses

The rules are different for non-spouses. Non-spouse beneficiaries cannot treat the IRA like their own, meaning they cannot make additional contributions, nor roll the assets into an IRA account in their own name. They are required to set up a new inherited IRA unless they want to collapse the account and distribute the assets as a lump sum payment.

Distributions From Inherited IRAs and the SECURE Act

With inherited IRAs, distributions may need to be taken, no matter what age you are when you open the account, or you may be expected to completely distribute the assets in the account within a required timeline. These rules don't apply if you've simply transferred a spouse’s IRA to your own IRA. The following information is specific to inherited IRAs.

The date of death of the original IRA owner and the type of beneficiary will determine the distribution method options. You must take an RMD for the year of the IRA owner's death if the owner had an RMD obligation that wasn't satisfied.

Ten-year rule

As a result of the SECURE Act of 2019, certain beneficiaries, known as "non-eligible designated beneficiaries," are required to deplete inherited retirement accounts within 10 years, otherwise known as the 10-year rule. Non-eligible designated beneficiaries are beneficiaries who are not a spouse, minor child, disabled, chronically ill or certain trusts.

Certain beneficiaries are exempt, however, including those whose age is within 10 years of the deceased’s, disabled or chronically ill individuals, and beneficiaries who are minors if they are direct descendants. Once the minor child reaches the age of majority, they will be subject to the 10-year rule as well. For beneficiaries in these categories, and those IRAs inherited prior to the end of 2019, the old rules apply.

Five-year rule for Roth IRAs

The five-year rule applies to taking distributions from an inherited Roth IRA. To withdraw earnings tax-free from an inherited IRA, the account must have been opened for a minimum of five years at the time of death of the original account holder.

The rules and available options regarding distributions from inherited IRAs are complex, and it is advised you speak with a qualified tax professional with experience dealing with U.S. retirement accounts, when setting up these accounts.

Inherited by a Non-Spouse Before 2020: “Stretch IRA”

As a result of the SECURE Act that came into effect January 1, 2020, changes were made to RMD requirements for retirement accounts inherited by a non-spouse. With these changes, where the IRA holder died after 2019, the beneficiary of the IRA must withdraw all funds under the 10-year rule. Prior to these changes, where the IRA owner died before 2020, the beneficiary could withdraw all funds under the five-year rule. Alternatively, they could take life expectancy payments starting the year after the account owner passed. This is referred to as a “Stretch IRA.” Distributing withdrawals over your lifetime mitigates your tax load. It is best that you reach out to a cross-border financial advisor to discuss this further.

Inherited IRAs and Canadian Beneficiaries

Canadian residents can be named beneficiaries of U.S. IRAs and retirement accounts. IRA payments to a Canadian beneficiary alien will be subject to a 15 per cent withholding tax and will be included on their Canadian tax return. The U.S. withholding tax paid will be a foreign tax credit to offset the Canadian taxes.

With the introduction of the 10-year rule noted in the previous section, payments from the inherited IRA may push the recipient’s income into a higher tax bracket. Also, unlike RRSPs, IRA payments cannot be split as pension income between spouses for Canadian tax purposes. These tax characters will need to be considered when deciding on whether to draw funds from the IRA or transfer the assets into a Canadian RRSP. It is important to note that the value of RRSP assets are generally taxable upon the death of the last surviving spouse. In contrast, IRA assets are taxable to the beneficiaries.

For Canadian beneficiaries, it is important to work with both an experienced cross-border tax professional and cross-border financial advisor to determine how the inherited IRA will impact your overall retirement plan.

Case Study

Here we provide an example of a situation involving an inherited IRA and a Canadian beneficiary.

The situation:

Joe is an American citizen and has done well for himself, building up a sizeable amount in his U.S. retirement account. He is not married and does not have any children. Joe decided to name his nephew Scott as his beneficiary. Scott is a Canadian citizen and resides in Canada. Joe passes away suddenly after 2019, and Scott is notified he is the named beneficiary of his uncle’s U.S. retirement account.

The issues:

1) Because Scott is a Canadian resident, Joe’s financial advisor is not able to work with Scott and maintain the retirement account.

2) Due to the size of the IRA, Scott is concerned about the amount of tax he would have to pay if he closes the account and liquidates the assets.

Solution:

Raymond James Snowbirds Wealth Management, as a dual-licensed financial advisory team, can assist Scott to navigate his options for the inherited IRA. Snowbirds Wealth Management can also introduce Scott to a qualified U.S. tax accountant who has experience with cross-border tax situations like this.

In consultation with his advisors, if Scott decides collapsing the account is not attractive, Scott can open an inherited IRA and defer the tax on the account for an additional 10 years under the SECURE act. Snowbirds Wealth Management, a Canadian advisory firm with a cross-border platform, can manage and maintain the account for Scott.

Snowbirds Wealth management will work with Scott and his tax professional to determine the optimal plan for withdrawing the assets.

FAQ

Q: Can amounts received from a deceased parent’s U.S. individual retirement account be rolled over to the recipient’s RRSP under a 60(j)?

A: No. The amount received from a deceased parent's U.S. individual retirement account would not be an eligible amount and, as such, is not eligible for the deduction under 60(j) of the Act.

Summary

Inherited IRAs are complex. As the rules continue to change and evolve, ensure you speak with a qualified tax professional if you find yourself the beneficiary of an IRA, or assisting with the settlement of an estate that involves a U.S. retirement account. And ensure you are working with an experienced and qualified cross-border advisory team to ensure you are considering all of your options.

Next Steps

If you’re planning on moving to Canada and need assistance with your investments, estate planning, and portfolio management, please call or email us at Snowbirds Wealth Management as we specialize in cross-border financial planning and wealth management. We work closely with experienced cross-border lawyers and accountants to ensure you have a team behind you.

About Snowbirds Wealth Management

Gerry Scott is a portfolio manager and founder of Snowbirds Wealth Management, an advisory firm focussed on the cross-border market. Together with Dean Moro and Carson Hamill, associate financial advisors and assistant branch manager with Snowbirds Wealth Management, they provide investment solutions for Americans living in Canada, and Canadians residing in the United States. Licensed in both Canada and the U.S., they provide tailored investment solutions to minimize the tax burden when moving assets across borders.To schedule an introductory call, please click here.

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