What Is the Right Option for a Spouse IRA Beneficiary?

The election by the spouse beneficiary of an IRA will affect the rate at which distributions must be taken and the income tax owed. And with the new restrictions explained under the proposed required minimum distribution regulations for Secure Act 1.0, the timing of elections is now added to the list of considerations for the decision-making process. Sometimes, the decision must be made before the spouse beneficiary accepts ownership of the IRA.

Background

The Secure Act, signed into law on Dec. 20, 2019, changed the distribution options for beneficiaries of IRAs and employer plans. Under these changes, the spouse beneficiary is among the few eligible to take RMDs from inherited accounts over their life expectancy. But the spouse beneficiary remains the only one who can move inherited IRAs to their own IRA or employer plan account.

The Department of the Treasury and the IRS published proposed RMD regulations on Feb. 24, 2022 (87 FR 10504), which explain that a new deadline now applies to when a spouse beneficiary may elect to treat an inherited IRA as their own. These proposed RMD regulations also limit a spouse beneficiary’s ability to use the five-year rule or the 10-year rule and then switch to their own IRA to avoid taking beneficiary life-expectancy distributions. But even with this new limitation, the spouse beneficiary still has three options available:

1. Beneficiary IRA
2. Treat-as-own
3. Rollover to their own

RMDs from a beneficiary IRA are calculated using the Single Life Expectancy table, using only the age of the spouse beneficiary or, in cases where the owner died on/after their required beginning date, or RBD, the longer of the life expectancy of the decedent or spouse beneficiary.

For the spouse’s own IRA, RMDs are calculated using the Uniform Lifetime table, based on the age of the spouse beneficiary and a beneficiary assumed to be 10 years their junior.

The Single Life Expectancy table produces RMDs that are significantly higher than the RMDs calculated using the Uniform Lifetime table.

The Beneficiary IRA Option

The spouse beneficiary who chooses the beneficiary IRA option would transfer the amount to an IRA registered in the name of the decedent and the surviving spouse: for example, Sharon Smith as Beneficiary of Mark Smith. The beneficiary IRA is also known as an inherited IRA in the IRA industry.

The IRA custodian must input Code 4-Death in Box 7 of Form 1099-R. Code 4 informs the IRS that the distribution is exempt from the 10% additional tax on distributions made before the age of 59½ (“early” distributions). This automatic qualification for the exemption from the 10% additional tax is one of the reasons why the beneficiary IRA option should be elected for a spouse beneficiary under age 59½. This benefit is lost if the spouse beneficiary moves the inherited IRA to their own IRA.

The spouse beneficiary who keeps the assets in a beneficiary IRA must take annual RMDs over their life expectancy if the 10-year (five-year if the owner died before 2020) rule does not apply. These annual RMDs must begin by Dec. 31 of the year following the year in which the IRA owner died or the year in which the IRA owner would have been required to start taking RMDs had they lived, whichever is later. The life expectancy RMD for the beneficiary is calculated using the Single Life Expectancy table.

The five-year or 10-year rule applies under the terms of the IRA agreement or election by the spouse beneficiary if the IRA owner dies before their RBD. Under the 10-year rule, distributions are optional (no RMDs) until the 10th year after the owner’s death, when the balance must be distributed. The five-year rule is similar, except that the final year is the fifth year.

The Treat-As-Own Option

A spouse beneficiary may elect to treat an inherited IRA as their own if they are the sole beneficiary and have an unlimited right to withdraw amounts from the IRA.

The election to treat an inherited IRA is made by the surviving spouse redesignating the inherited IRA in their name. The name of the decedent is not included in the registration.

Not taking beneficiary RMDs within the required time and/or making a regular IRA contribution or 60-day rollover contribution to the inherited IRA would result in the “treat as own” election. However, I am unaware of any IRA custodian that permits regular IRA contributions to be made to inherited IRAs.

The code in Box 7 of IRS Form 1099-R is driven by age and whether the spouse beneficiary qualifies for any certain exceptions to the additional tax on early distributions. Code 1-Early distribution, no known exception is used if the spouse beneficiary is under age 59½, and the distribution is not made under any of the following circumstances:

• Due to an IRS levy
• While the IRA owner is disabled
• For a conversion directly to a Roth IRA
• Under a substantially equal periodic payment program

Otherwise, Code 2-Early distribution, exception applies would be used, except for disability, where Code 3-Disability, would be used.

Code 7-Normal distribution is used once the IRA owner reaches age 59½ and is, therefore, generally free from the 10% additional tax on early distributions.

The spouse beneficiary is treated as the owner (not a holder of an inherited IRA) as of Jan. 1 of the year the election was made to treat the inherited IRA as their own, and this means they are permitted to make regular IRA contributions, perform Roth IRA conversions, and perform rollovers and transfers under the owner (nonbeneficiary) rules.

RMDs for the spouse’s own IRA would be calculated using the Uniform Lifetime table.

New Deadline for Treating As Own

No longer can we tell spouse beneficiaries that they have forever and a day to elect the treat-as-own option for inherited IRAs. Instead, the proposed RMD regulations for Secure Act 1.0 explain that the deadline for a spouse beneficiary to treat an inherited IRA as their own is the later of:

1. The end of the calendar year in which the surviving spouse reaches their applicable RMD age, and
2. The end of the calendar year following the calendar year of the IRA owner’s death.

If a spouse beneficiary misses the deadline to treat an inherited IRA as their own, there is still hope, as they can roll over the amount instead. But any beneficiary RMD due must be taken before the rollover.

The Rollover Option

A spouse beneficiary may roll over an inherited IRA to their own IRA.

However, this rollover may not include RMDs. The proposed RMD regulations explain that a spouse beneficiary who elects the five-year or 10-year rule and later decides to roll over the beneficiary IRA to their own is subject to a hypothetical RMD. This hypothetical RMD applies if the amount being rolled over is distributed before the fifth or 10th year of the five- or 10-year period and in or after the year the spouse beneficiary attains the age at which RMDs must begin from their own IRA.

This hypothetical RMD is the RMD that would have applied for years up to the year of the rollover had the spouse beneficiary elected to take distributions over their life expectancy instead of under the five- or 10-year rule—and it is reduced by any distributions taken by the spouse beneficiary during those years.

The 1099-R reporting requirements are the same as those that apply to the treat-as-own option once the assets have been rolled over.

After the rollover, RMDs would be calculated using the Uniform Lifetime table.

Note: A spouse beneficiary may also roll over eligible amounts to their own account under an employer’s qualified plan, 403(b), or governmental 457(b) plan.

Choosing the Right Option

A spouse beneficiary who chooses the beneficiary IRA option can move the assets to their own IRA later. But once the assets are moved to the spouse beneficiary’s own IRA, there is no turning back. Therefore, the beneficiary IRA option should be chosen when there is uncertainty about which option is best. The assets can then be moved to the spouse beneficiary’s IRA when tax-beneficial.

Ultimately, which option is right for a spouse beneficiary depends on their beneficiary profile, including whether they need to avoid the 10% additional tax and/or minimize distributions.