Inherited IRA

If you recently inherited an IRA or employer-sponsored retirement account, you must plan how to handle estate planning and taxes. Usually, depending on your relationship with the deceased retirement account holder, there may be different rules for handling the inherited assets.

An inherited IRA is opened when an individual inherits an IRA or other retirement plan after the original account holder dies. It can be opened by a spouse, child, brother, parent, or other named beneficiary of the deceased account holder. A beneficiary cannot make additional contributions to the inherited IRA but can make withdrawals at any time penalty-free.

What is an Inherited IRA?

An inherited IRA, also known as a beneficiary IRA, is a type of IRA that is opened when you inherit an IRA or employer-sponsored retirement account after the original owner dies. An heir is required to move the inherited assets from the deceased account holder's\ account to an inherited IRA in the heir's name.

Generally, anyone can inherit a tax-advantaged retirement account. An eligible beneficiary can be a spouse, child, brother, parent, other relative, or an entity. Different tax rules apply depending on your relationship with the deceased retirement account holder.

How does an inherited IRA work?

An inherited IRA is specifically designed to hold retirement assets from the original retirement account, which can be a traditional IRA, Roth IRA, SIMPLE IRA, SEP IRA, 401(k), etc. The money in the inherited account will continue growing tax-deferred, but the beneficiary won't be allowed to contribute to the retirement account.

Generally, the tax treatment of the inherited assets remains the same as the original retirement account. For example, if you inherited a Roth IRA, you would need to open an inherited Roth IRA, and the money will grow tax-free until you make withdrawals from the account.

Inherited IRA: Rules for Spouses

If you inherited a traditional, Roth, SEP, or SIMPLE IRA from your deceased spouse, you have more flexibility in handling the inherited assets than other beneficiaries.

First, the spouse can rollover the IRA or a part of the money into their IRA account. This option allows the spouse to name their own beneficiaries and deal with the retirement assets as their own. The distribution rules and withdrawal penalties for IRAs are the same.

If the spouse is under age 59 ½, they will be subject to withdrawal penalties as if the IRA had been theirs originally. Additionally, if the original account holder had begun receiving the Required Minimum Distributions (RMDs), the spouse must continue taking these distributions or create a new distribution schedule based on their life expectancy.

The spouse can also take a lump sum distribution from the inherited IRA. If the spouse inherits a traditional IRA, they will pay income taxes on the distribution taken, but won’t owe an early withdrawal penalty. If you inherited a Roth IRA, all the assets in the account will be available for distribution immediately. However, if the Roth IRA was less than 5 years old at the time of the account holder's death, the distributions will be subject to income taxes.

Inherited IRA: Rules for non-spouses

If you inherited an IRA or an employer-sponsored retirement account from someone other than your spouse, there may be different withdrawal rules from those available to a surviving spouse. 

As a non-spouse beneficiary, you must take the full distribution from the inherited IRA within 10 years following the death of the original account holder. You can withdraw money from the retirement account at any time during the 10 years as long as the entire retirement money is fully distributed by the end of the 10^th year.

If the account holder had begun taking RMDs before they died, the beneficiary must continue taking the RMDs during the 10-year period. If the account holder did not take an RMD in the year of death and they were required to, the beneficiary must take the mandatory distribution by 31 December of the year the account holder died.

If you are an eligible designated beneficiary, such as a minor child, someone who is chronically ill or permanently disabled, or a beneficiary who is no more than 10 years younger than the original IRA owner, you may still have the option to stretch distributions over your lifetime.

If the beneficiary is a minor child of the deceased, the life expectancy distribution will not be available to them when they turn 21. At this point, they are required to switch to the 10-year distribution method and must take the full distribution by the end of the 10 years after turning 21.

Options for receiving benefits from Inherited IRA

Inherited IRA beneficiaries may have several options for receiving the inherited retirement assets. The options you have with the money depend on your relationship with the original account holder, with spouses having more options than non-spousal beneficiaries.

Here are the options available to beneficiaries:

Transfer assets to an inherited IRA

You can open an inherited IRA to transfer the inherited retirement money. You won't be allowed to make additional contributions to the plan or roll over other retirement accounts into the inherited IRA. However, you will be allowed to make withdrawals at any time penalty-free; the tax implications will depend on the type of retirement account you inherited.

Be aware that the spouse must empty the IRA by the 10^th year after the original account holder’s death. For example, if you inherited a traditional IRA, you will pay income taxes on the distribution.

Take a distribution

You can choose to take a lump-sum distribution to access the inherited retirement assets immediately. You will pay income taxes on the entire distribution, which could push you to a higher tax bracket. Be aware that you will miss out on years of tax-deferred growth if take a lump sum distribution.

Roll over into an IRA

This option is only available to the spousal beneficiary. If a spouse inherited retirement assets from their deceased spouse’s traditional IRA, they are allowed to roll over these proceeds to their traditional IRA.

Rolling over into your own IRA is a good option if you are age 59 ½ or older to avoid incurring a 10% early withdrawal penalty. RMDs will be based on your age and determined using your life expectancy.

Disclaim the inheritance

If the beneficiary does not need the inheritance, they can choose to disclaim the inheritance. This option transfers rights to the inheritance you received to the remaining beneficiaries of the deceased account holder. If there are no primary beneficiaries named, the proceeds will go to contingent beneficiaries. If no other beneficiary is named, the inheritance will be paid to the deceased account holder’s estate.