How to Handle an Inherited IRA

By Marla Brill | Jun 10th, 2019

IRAs held nearly $9 trillion at the end of 2018, more than a nine-fold increase from 1993. The fact that they’ve become so popular increases the odds that you will inherit an IRA, pass one along to heirs, or both.

The tax treatment of inherited IRAs is complex and making the wrong move can be costly. The rules are different for spouses than they are for other relatives or friends. Individual factors such as your age, the age of the account owner, and whether you prefer to receive a large payment or maximize tax-deferral strategies also come into play in deciding how to handle things.

Non-Spouse Beneficiaries

The rules for non-spouse beneficiaries apply whether you are a sibling or a distant cousin or friend of the account owner.

With a traditional IRA, a 10 percent early withdrawal penalty usually applies for distributions before age 59 1/2. In most cases, that penalty does not apply for an inherited IRA, regardless of age. But you still need to pay income taxes on any withdrawals.

Typically, the first step is to transfer the money from a traditional IRA to an inherited IRA held in your name. After that, you have to decide how to take the money out using one of several options.

• If the original IRA account owner died after reaching age 70 1/2–the age at which required minimum distributions (RMDs) kick in– distributions are taken based on your life expectancy or the life expectancy of the original owner at the age of death, whichever is longer. RMDs generally must begin in the year following the year of death.
  
• If the original account owner died before reaching age 70 1/2 you may also use the five-year rule, which allows for distributions over a five-year period. All assets must be removed from the account by December 31 of the fifth year following the account owner’s death, and beneficiaries can withdraw as much or as little as they want over that period. Although this method often allows for larger withdrawals over a relatively short period of time, taxes may be higher than under the life expectancy method.
  
• Alternatively, you can take the money as a lump sum and pay taxes on the distribution all at once. Depending on the size of the account and your current income, this could move you into a higher tax bracket. But if you desperately need the money, or the account is small, this could make sense.
  
• In cases where there is more than one beneficiary, you may want to transfer your share of the IRA into your name and take the first RMD by December 31 of the year after the decedent’s death. Otherwise, the RMD calculation could be based on the age of the oldest beneficiary.
  

Non-spouse beneficiaries should be aware that inherited IRAs are not protected from creditors in bankruptcy under federal law, although some states may offer such protection.

Spousal Beneficiaries

The rules are a bit more flexible when it comes to spousal beneficiaries. In these cases, there are several options available:

• Treat the inherited IRA as your own by putting the account in your name. This leaves the surviving spouse free to make additional contributions and to allow the money to continue to grow tax-deferred. But it also subjects the account to early withdrawal penalties for those under age 59 1/2, and required minimum distributions based on the age of the new account owner must be taken at age 70 1/2. In order to make this election, the spouse must be the only designated beneficiary.
  
• Roll over the account into a new or existing IRA. You must do this within 60 days of the distribution, and the rollover may not include amounts subject to RMDs. This is a good option when there are several beneficiaries, since, a spouse need not be the sole beneficiary to roll over his/her proportional share of the inherited IRA to another account. Withdrawal rules for ordinary IRAs apply.
  
• Elect to be treated as a beneficiary. This entails opening up an inherited IRA, much as a non-spouse beneficiary would. By going this route, spouses under age 59 1/2 can make withdrawals from the account without incurring a penalty.
  
• Take the lump sum and pay the applicable taxes all at once.
  

Be aware that the rules for particular plans can vary from one firm to another, and they don’t always conform to IRS guidelines. For example, some may have not had the full range of withdrawal options allowed by government guidelines. Additionally, the rules for estates and trusts differ from those of designated beneficiaries. To evaluate the potential impact an IRA inheritance may have on your taxes, consult a tax advisor.