Inheriting an IRA 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 can get a little confusing. Unfortunately, you might have to make financial decisions about the account while dealing with mixed emotions. It’s not a simple task. But it’s important to follow the rules carefully, as there are a number of potential tax penalties or benefits that can apply to inherited IRAs.
What Is an IRA?
Let’s review the basics: IRAs are tax-advantaged accounts 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 your IRA inheritance? The answer depends on your relationship with the account holder.
Inherited Traditional IRA Rules for 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 1/2 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 1/2 years old. The other rule is that once you reach 70 1/2 years of age, you must start withdrawing funds from the account. It’s the IRS’s way to ensure traditional IRAs are used for your retirement, not as an indefinite tax-advantaged savings account.
Inherited Roth IRA Rules for 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. You won’t be hit with 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.
Inherited IRA Rules for Children
If a parent leaves you an IRA, you’re considered 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’re not allowed to retitle the IRA in your own name. That benefit is reserved for spouses. You can, however, transfer the account into a new account, which is known as an “inherited IRA.”
Your Options as a Non-Spouse Beneficiary
You can immediately cash out traditional or Roth IRAs. This is known as a lump sum distribution. With traditional IRAs, the withdrawal is considered taxable income, but with Roth IRAs, as long as the account was open at least five years, the beneficiary can withdraw it tax-free. The downside of taking all the money out immediately is that you lose the long-term benefits that occur when the money is allowed to grow 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 interested in stretching out the lifespan of the IRA, you’d use what’s called the single life expectancy calculator method to determine the required minimum distributions. 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 complicated 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.
Remember, you don’t have to figure it out on your own. It can give you peace of mind to turn to an expert for help, such as a financial advisor if you’re not quite sure what to do. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three registered investment advisors who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
Tips for Inheritance
- Surviving family members can learn about Social Security death benefits. The subject’s complicated, but it’s worth taking the time to see if the benefits apply to you.
- Unfortunately, death and taxes go hand-in-hand. Stay on top of it by learning what you owe the government when a family member dies.
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