Inheriting an IRA, whether a traditional or Roth account, comes with certain responsibilities. The rules for an inherited IRA depend on the specifics of your situation, as well as the deceased’s age and other circumstances. Unfortunately, you might have to make financial decisions about the account while dealing with your grief. Be sure to follow the government’s rules carefully, as there are a number of potential tax penalties or benefits that can apply to you and the IRA.
Many financial advisors are experts in retirement accounts and estate management. Ask a financial advisor about your situation today.
What Is an IRA?
An individual retirement account, or IRA, is a tax-advantaged account designed for retirement savings. They can hold stocks, mutual funds, bonds and a variety of other financial products. Your money earns interest and grows, tax-free. Until you reach retirement age, you don’t pay income tax or capital gains tax on the money in the account.
There are two major types of IRAs: traditional and Roth. With traditional IRAs, you contribute pre-tax earnings which are considered tax deductible. When you retire and start taking distributions from your IRA, those distributions will be taxed as income. For Roth IRAs, you contribute taxed income (and your contributions aren’t tax deductible) and when you retire, your withdrawals are tax-free.
So what happens when an IRA changes ownership, such as in the case of an IRA inheritance? The answer depends on your relationship with the former account holder.
Rules for Inheriting a Traditional IRA: Spouses
The IRS lists three options for spouses who inherit a traditional IRA. If that’s you, the first option is to designate yourself as the account owner. You’ll put the account under your name (also known as “retitling”). This way, the account is yours to contribute or withdraw from. Keep in mind, in most circumstances you have to be 59.5 or older to withdraw from an IRA without penalty.
Your second option is to roll the inherited account – tax-free – into an IRA you already possess. If you have an employer retirement plan, you can roll the inherited IRA into that account, as well. In both of these situations, you become the owner of the IRA.
The third option is to treat the account as a beneficiary, not as the owner. This could mean withdrawing the money in a lump sum, but that’s not your only choice. Treating the account as a beneficiary also means you have the option to transfer the assets to an “inherited IRA” held in your name. This will come with required minimum distributions (RMDs). We’ll talk more about RMDs under non-spouse IRA inheritance rules.
For the first two options, since you’re treating the assets as your own, you can’t withdraw until you’re 59.5 years old. The other rule is that once you reach 70.5 years of age, you must start withdrawing funds from the account. It’s the IRS’ way to ensure traditional IRAs are used for your retirement, not as an indefinite tax-deferred savings account.
Rules for Inheriting a Roth IRA: Spouses
If you inherit a Roth IRA as a spouse, you can withdraw any or all of the account, tax-free, provided the account has existed for at least five years. In this case, you will not be charged the 10% early withdrawal penalty.
If you’d rather not take the Roth IRA as a lump sum, you have options. The better option for long-term savings is to transfer the assets to an existing Roth or to open a new Roth IRA. The account can grow without penalty, due to the lack of required minimum distributions. You can also leave the money in the account to grow indefinitely for the next generation. This is one of the biggest differences between Roth and traditional IRAs.
Rules for Inheriting an IRA: Children and Other Non-Spouse Beneficiaries
If a parent leaves you an IRA, you are the beneficiary. The IRS calls this situation a non-spouse inheritance. Parent to child is the most common non-spouse situation, but it’s not exclusive. As a non-spouse beneficiary, you cannot retitle the IRA in your own name. That benefit is only available for spouses. You can, however, transfer the account into a new account. This is known as an “inherited IRA.”
You can immediately cash out traditional or Roth IRAs through a lump sum distribution. With traditional IRAs, withdrawals are taxable income. However, withdrawals from Roth IRAs (as long as the account was open for at least five years) are tax-free. The downside of taking all the money out immediately is that you lose the long-term benefits that occur when the money grows within the IRA. However, it is an option if you need funds right away.
If you only want to withdraw some money, but not all, you can do so. You have to transfer the account to an “inherited IRA” held in your name. In most cases, you’ll have to withdraw all account funds by December 31 of the fifth year following the account owner’s death. This becomes your default option December 31 of the year following the account owner’s death if you don’t proactively choose any other option.
While the baseline requirements state that the account must be withdrawn in full by the fifth year after inheritance, there is a tactic known as “stretching out” an inherited IRA. If you’re looking to do this, you can use the single life expectancy calculator method to determine the RMDs. The IRS has a formula (based on your age and the size of the account) that tells you how much to withdraw each year. This option is a little more complicated than standard lump sum or five-year withdrawals.
Inheriting retirement accounts can be stressful. As it stands, the rules are complex and not the most user-friendly. You’ll want to make sure you understand all of your options before making any decisions about your inheritance. It’s always better to take your time with financial decisions.
Tips for Heirs
- When you inherit an IRA, there are many rules to follow depending on your relationship to the account owner. A financial advisor can help you understand what you have to do, as well as answer any related questions you might have. Luckily, finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool can match you with up to three advisors in your area in five minutes. Get started now.
- If you’re a surviving family member of the decedent, you should learn about Social Security death benefits. You should also review what you might owe in taxes when a family member passes.
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