Inheriting an IRA comes with specific rules and potential tax consequences that vary depending on your relationship to the original account holder and the type of IRA you’ve inherited. Whether it’s a traditional IRA with tax-deferred contributions or a Roth IRA with tax-free distributions, each has distinct requirements for beneficiaries. The SECURE Act significantly changed the landscape by eliminating the “stretch IRA” option for many non-spouse beneficiaries, requiring most inherited accounts to be fully distributed within 10 years. This change can have substantial tax implications, potentially pushing beneficiaries into higher tax brackets during the distribution period.
A financial advisor can help you create an estate plan for your family’s needs and goals.
IRA Inheritance From a Spouse
If a spouse gifted you a traditional IRA, you can roll its funds into any existing IRA you own. The money will continue to grow on a tax-deferred basis. Tax-wise, the new IRA recipient is subject to the same tax rules as any IRA holder. You’ll have to pay taxes on any distributions taken out of the account at current income tax rates. If you take those distributions before you reach the age of 59.5, you’ll likely have to pay a 10% early withdrawal penalty fee to the IRS.
Ensure that any IRA withdrawals are above the annual required minimum distribution (RMD). The RMD is the minimum amount an IRA stakeholder must take out of a plan after turning 70.5 years old. This value is based on the size of your account at the end of the preceding calendar year. The IRS website has tables that you can use to see the size of your RMD for the year.
A second option for inheriting IRA assets from your spouse is to instead transfer them into an inherited IRA. This is best for people who have not yet reached the age of 59.5 and wish to take distributions. That’s because you can start taking distributions from an inherited IRA early, without incurring the 10% penalty.
As for the RMDs for inherited IRAs, there are two sets of rules. Under the five-year method, you need to have taken all assets by December 31 of the fifth year after the year the original account holder. Alternatively, you can wait until the year the original account holder would have turned 70.5, and then begin taking RMDs according to the IRS tables.
IRA Inheritance From a Parent, Grandparent or Older Family Member
If you’re not the spouse of the original IRA holder, you can’t roll the new IRA into an existing IRA. The good news is that you’re not subject to the 10% penalty tax if you’re younger than 59.5 when you start taking distributions.
You do, however, have to take distributions fairly quickly. Generally speaking, you must take the first distribution by December 31 of the year the original plan recipient passed away. Those distributions will follow the IRS RMD schedule. If, however, the original account holder died before reaching 70.5, you can instead use the five-year method. Under this method, you don’t have to take the distributions starting that year, but you must distribute all of the inherited assets within five years.
Other than that, the recipient must still pay taxes as usual on any distributions coming out of the new IRA. IRA recipients who were gifted an IRA plan from a spouse or a parent share one common tax-related risk. By accepting the IRA assets, the recipient runs the risk of moving up to a higher tax bracket. That could mean digging into your pocket to pay more money to Uncle Sam come tax time, especially if you’re already having a high-income year.
A trusted tax attorney or a qualified financial advisor can walk you through the different options that might minimize being moved into a larger tax bracket. This could include avoiding taking lump sum distributions and/or rolling the IRA’s funds into an existing account for your own retirement needs down the road.
Other IRA Inheritance Situations
If you’re a Roth IRA recipient, know that with a Roth plan, the assets are funded with post-tax income. This enables the account holder to accept distributions without having to pay any income tax. This means that if you inherit a Roth IRA, any distributions you take are not subject to taxation.
Otherwise, the same rules apply. If you’re receiving the Roth IRA from your spouse, don’t take distributions until you turn 59.5, lest you get hit with the 10% penalty tax. And be sure to start taking distributions before you turn 70.5. If you’re a non-spousal recipient, start taking your (tax-free) distributions immediately.
Gifted IRA recipients have several options available if they accept an inherited IRA and elect to cash out immediately. Again, while you’ll pay income taxes, you won’t have to pay the 10% early withdrawal penalty. You do, however, have to cash in the entire gifted IRA by the end of the year. Just know that cashing in all assets immediately with a gifted IRA could mean a big tax bill. State-issued taxes could apply, as well.
If that doesn’t work for you, slow things down and take out the IRA’s fund proceeds on a steady timeline. Your best move here is to establish an inherited IRA account, naming you, the recipient, as the beneficiary. Under this arrangement, you must take out required minimum distributions annually based on your estimated life expectancy under the IRS’ guidelines. Some accountants refer to this option as the “Stretch IRA,” as it allows you to take slower withdrawals out of an inherited IRA at regular intervals.
Inherited IRA Rules
Whether you are a spouse, non-spouse, or entity inheriting an IRA, the guidelines can significantly impact your tax obligations and withdrawal strategies. Here are some rules you need to understand if you’re leaving behind an IRA or inheriting one.
- Types of beneficiaries: The rules for inherited IRAs vary depending on whether you are a spouse, non-spouse, or entity beneficiary. Spouses can treat the IRA as their own, while non-spouse beneficiaries must follow specific distribution rules. Entities, such as trusts or estates, have guidelines that can affect how and when distributions are made.
- Required minimum distributions (RMDs): Non-spouse beneficiaries are generally required to take RMDs based on their life expectancy or within 10 years. Spouses can delay RMDs until the deceased has reached age 72, offering more flexibility in planning. Understanding RMD requirements is essential to avoid penalties and optimize tax efficiency.
- Tax implications: Withdrawals from an inherited IRA are typically subject to income tax, but the timing and amount can influence your tax bracket. Strategic planning can help minimize tax liabilities, especially in a higher tax bracket. Consulting with a tax advisor can provide personalized strategies to manage these implications effectively.
- Distribution options: Beneficiaries have several options for taking distributions, including lump-sum withdrawals, life expectancy payments, or the 10-year rule. Each option has its advantages and potential drawbacks, depending on your financial goals and needs. Evaluating these options can help you choose the best path for your situation.
Understanding inherited IRA rules is essential for maximizing the benefits of your inheritance while adhering to legal requirements. Always consider seeking professional advice to tailor your approach to your unique circumstances.
Tips for Inheriting an IRA
Inheriting an IRA comes with specific rules and considerations that can significantly impact your financial future. Understanding these guidelines can help you maximize the benefits while avoiding costly mistakes.
- Understand your beneficiary status: Your relationship to the original account holder determines your options. Spouses have the most flexibility, including the ability to roll the inherited IRA into their account or remain a beneficiary. Non-spouse beneficiaries face more restrictions and typically must follow the 10-year distribution rule established by the SECURE Act.
- Learn the distribution rules: The SECURE Act eliminated the “stretch IRA” option for most non-spouse beneficiaries. Now, most inherited IRAs must be fully distributed within 10 years of the original owner’s death. However, certain eligible designated beneficiaries, including minor children and disabled individuals, may still qualify for extended distribution periods.
- Consider tax implications: Distributions from traditional inherited IRAs are generally taxed as ordinary income. Taking large distributions could push you into a higher tax bracket, potentially increasing your tax burden. Strategic planning of withdrawals over the allowed timeframe can help minimize the tax impact.
- Meet required minimum distributions (RMDs): If the original account holder was already taking RMDs, you’ll need to continue taking them. Failing to take required distributions can result in a substantial 50% penalty on the amount that should have been withdrawn.
- Consult with professionals: The rules for inheriting an IRA are complex and can change with new legislation. Working with financial advisors and tax professionals who specialize in retirement accounts can help you navigate these complexities and develop a strategy that aligns with your financial goals.
Understanding these tips for inheriting an IRA can help you make informed decisions that preserve the account’s value while meeting your financial needs and obligations.
Bottom Line
When inheriting an IRA, understanding the tax implications is crucial for making informed financial decisions. The rules differ significantly depending on your relationship to the original account holder and the type of IRA you’ve inherited. Non-spouse beneficiaries generally must withdraw all funds within 10 years, while spouses have more flexible options, including treating the inherited account as their own.
Tips for Managing Your Retirement Plans
- Managing your retirement assets can be a lot to handle on your own but a financial advisor can help you with the entire process. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Curious how far your current assets will get you in retirement? Our retirement calculator can help shed some light on the matter. Just tell us where you plan to retire, your current annual income, your monthly savings, your anticipated annual retirement expenses and your Social Security election age. Using this information, you can see how much more you need to save to reach your goals.
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