How To Handle An Inherited IRA

How To Handle An Inherited IRA

When a loved one dies, one of the last things on your mind is their IRA you’ve inherited, but as the beneficiary you’ll eventually have to decide how to handle it. The IRS rules for distribution of inherited IRA funds are different depending on several circumstances. Here’s what you need to know. 

Spousal Beneficiary

A spouse who is the sole beneficiary of an IRA may choose to do any of the following options:

• Take a taxable lump sum distribution. This move is subject to income tax, but a 10% penalty for early distribution prior to age 59 ½ does not apply. Be aware, though, that this may bump you into a higher tax bracket, since the money will be counted as income earned for that year.
• Add the assets to your existing retirement savings. Either treat the IRA as your own, retitling it so you’re listed as the owner instead of your spouse, or roll the funds into an existing traditional IRA, essentially pooling your retirement assets. As long as you transfer any distributions to a new account within 60 days, you won’t be taxed on the distribution, and the money can continue to grow tax-deferred.
• Consider lifetime distributions. Take distributions every year, on an annual basis. How much you take depends on the value of the account at the beginning of the year, and the Required Minimum Distribution (RMD) will be determined by the IRS and a set life expectancy table.
• Opt for the 5-year spend down. If the IRA holder hadn’t started to take required minimum distributions before death – typically age 70 ½ – beneficiaries have the option to keep inherited IRA assets in the account for up to five years after death, at which point the full amount of the IRA must be withdrawn.

Spousal beneficiaries of Roth IRAs have the same options as traditional IRAs, but distributions are tax-free as long as the Roth account is at least five years old. If the account is less than five years old at the time of the owner’s death, earnings are taxable when distributed.

Non-spousal Beneficiary

If you’re inheriting an IRA from a parent, sibling, relative, or friend, you aren’t permitted to roll the inherited IRA into an existing IRA. Instead you must open a new inherited IRA to which the funds will be transferred. You can’t make new contributions to this account, and you must begin withdrawing assets no later that December 31 of the year after the account holder passed away.

Distributions will be considered part of your annual income and could possibly bump you into a higher tax bracket. However, if you don’t take the necessary distributions, you will be subjected to a 50% tax penalty on the amount taken out below the RMD.

Options available to you for taking distributions include: a lump-sum payment, in which case you won’t be charged a 10% early withdraw penalty, even if you’re under age 59 ½, though you will still pay taxes on the money; a five-year distribution plan, in which there won’t be any required minimum distributions, but all the money will need to be withdrawn from the account by the end of five years; and the life expectancy method, in which withdraws are calculated by the IRS.

Non-spousal beneficiaries of Roth IRAs have the same options as spousal beneficiaries except for treating the inherited Roth IRA as their own (i.e. rolling the inherited Roth IRA into their own IRA is not an option).