Inheriting an IRA? Here are the options and withdrawal rules beneficiaries should know
If you're on the receiving end of an inheritance, odds are the money is coming to you out of the deceased's retirement account. And you may be asked — or sometimes told — to set up an Inherited IRA.
Inherited IRAs (investment retirement accounts) are accounts a person sets up with the funds bequeathed to them after an IRA owner dies. Basically, they're the same tax-deferred vehicles as regular IRAs. But how you, the beneficiary, handles them — well, "It's complicated," says Peter Riefstahl, a CPA at Louis T. Roth & Co., PLLC. "The rules vary depending on your relationship to the deceased, at what age they died, and what type of beneficiary you are."
Understanding those rules is crucial to getting the most out of the inherited IRA — and avoid running afoul of the IRS. Here's an overview of how they work.
What is an Inherited IRA?
Also known as a beneficiary IRA, an Inherited IRA is an account that holds the assets inherited from a deceased person's IRA. Inherited IRAs can be funded from any type of IRA: including traditional, Roth, Simple, and SEP-IRAs. It can also be created out of money from the deceased's 401(k) plan.
You can set an Inherited IRA up with most any bank or brokerage. However, the easiest option may be to open your Inherited IRA with the firm that held the deceased's account.
For tax purposes, it's important that the account be named properly — designated as inherited, and with both parties' names. Typically, the title reads something like: [Name of Recipient] Inherited IRA Beneficiary of [Deceased's name].
The person or entity that inherits the IRA can be anyone that the deceased person named as a beneficiary in the IRA paperwork. It's this designation that dictates who inherits the IRA — even if the deceased's will names somebody else.
What to do with an Inherited IRA
All beneficiaries have the option to cash out their inheritance: Take a lump-sum withdrawal from the deceased's IRA and shut it down — though experts usually advise against this strategy since doing so can incur a whopping tax bill.
Different beneficiaries have different options
Beneficiaries fall into two categories: designated (people, like a spouse, relative, or friend) and not-designated (trusts, estates, charities).
Spouses can set up an Inherited IRA. But it's usually more advantageous to treat the deceased's IRA as their own: putting it into their name, or rolling it over into another IRA they already have.
In contrast, non-spouse beneficiaries — everybody else, basically — has to set up a separate Inherited IRA.
Beyond that, your handling of the Inherited IRA depends on your relationship to the deceased.
While the rules are many and varied, there are two big takeaways:
How Inherited IRA withdrawals work
Spouses have the most flexibility. If they've just put the deceased's IRA in their name or rolled the money over into their own IRA, they just have to start taking out money when they turn 72 — the usual IRA rule of required minimum distributions (RMDs). If they've set up a new Inherited IRA, they take the same distributions the deceased did, or recalculate the amount based on their own life expectancy.
For most other individuals, withdrawals from the Inherited IRA can be made in any amount at any time. The key point: The beneficiary has 10 years (to the end of the calendar year) following the original account owner's death to withdraw all assets from the Inherited IRA.
For example, say Papa Joe passes away on September 1, 2020, bequeathing his IRA to his grown daughter Jane. Jane sets up an Inherited IRA. Her deadline for emptying the IRA is December 31, 2030.
What happens if you don't withdraw funds from an Inherited IRA
The consequences of missing withdrawals can be harsh. The IRS charges a penalty of 50% of the funds you were supposed to take out. Depending on the size of the IRA that you inherit, this can be serious money.
The tax rules regarding Inherited IRAs
Tax rules that applied to the original IRA also apply to an Inherited IRA. Just like an IRA that you've funded yourself, money within the account grows free of income tax.
IRAs that have taxable withdrawals, such as Traditional IRAs and SEP-IRAs, continue to be taxable when withdrawn from their inherited counterparts. Any amount withdrawn is taxed at your regular income tax rate.
Inherited Roth IRA distributions continue to be tax-free, just like any Roth's, as long as the deceased's original account is at least five years old. If it has been less than five years, any withdrawn contributions are still tax-free, but any earnings above that are taxable when you take them out.
The IRS does offer beneficiaries one break. Typically, if you're under age 59-½, any withdrawals from Traditional IRAs and withdrawals of earnings from Roth IRAs are subject to a 10% penalty. This penalty is waived for Inherited IRAs.
How the SECURE Act affected Inherited IRAs
The SECURE Act of 2019 changed many retirement account rules, including Inherited IRAs. It only affects IRA funds inherited Jan. 1, 2020, or later.
The biggest impact hits non-spouse beneficiaries. Previously, these heirs had to withdraw funds annually from an Inherited IRA, but they could base the amount on their own life expectancy. Depending on the beneficiary's age, this amount could be pretty small, and so would the income tax due. This made bequeathing IRAs to young children or grandchildren a popular estate-planning strategy.
But no more. The SECURE Act says these beneficiaries have to empty the inherited IRA within a decade of the original owner's death. Exceptions are made for disabled or chronically ill individuals, those whose age is within 10 years of the deceased's, and direct descendants under the majority age of 18. (And once they turn 18, they're under the 10-year withdrawal deadline too.)
Everyone who sets up Inherited IRAs before the end of 2019 can still follow the old life expectancy rules for distributions.
The financial takeaway
Unless you're a spouse, when you inherit a retirement account, your usual best option is to transfer the money into an Inherited IRA. Inherited IRAs continue to grow tax-deferred until withdrawals are made. Taxes on withdrawals are treated the same as the original IRA account.
Spouses aside, most beneficiaries must withdraw all funds from their Inherited IRAs within 10 years. They can withdraw assets on any schedule they wish.
"One could simply defer taking withdrawals for the decade, let the account grow (ideally), and then take it all out in the end," says Peter Riefstahl. "The important caveat is that this will push you into a far higher tax bracket, thereby cutting into those gains that have accumulated over the years."
The rules for Inherited IRAs are complex, and the variations are many. Our rundown covers just the basics. So before making any moves, definitely consult with a tax or estates-law professional regarding your particular circumstances.
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