What Happens When You Inherit An IRA?

You’ve inherited an individual retirement account (IRA) – now what? Should you spend that money or save it for later? What are the consequences of either choice? Although there are several rules to follow regarding the method and timing of distributions from inherited IRAs, it is important to understand that distributions from inherited IRAs are not subject to the usual 10% penalty for distributions received before you reach age 59 ½. The IRS rules for distribution of inherited IRA funds are different depending upon several conditions:

• Whether the IRA owner died before his or her beginning date for required minimum distributions (RMDs).
• Your relationship with the deceased IRA owner (spousal or non-spousal)
• Whether the inherited account is a traditional IRA or a Roth IRA

Spousal beneficiary of traditional IRA

If you inherited a traditional IRA from your spouse and were named the sole beneficiary, you may choose any of these options:

• Own it. Treat the IRA as your own, even rolling it into an existing traditional IRA in your own name. Electing this option means the same rules and penalties apply to amounts withdrawn prior to you reaching age 59½. Assets will continue to grow tax-deferred.
• Lifetime distributions. Open an inherited IRA (make sure it’s labeled “inherited”), transfer the inherited assets into it, and take annual distributions over your lifetime. Distributions need not begin immediately, but they must start no later than December 31 of the year in which your spouse would have turned 70 ½ or December 31 of the year following the year of death, whichever is later. If your spouse was age 70 ½ or older upon death, then distributions must begin no later than December 31 of the year following the year of death. These lifetime distributions are taxable, but they are not subject to a 10% penalty for early distribution if you are under age 59 ½.
• Five year spend down. Open an inherited IRA, transfer the inherited assets into it, and take distributions of the full amount over a five year period. By the end of the fifth year, all inherited IRA assets must be distributed to you. These distributions are taxable, but they are not subject to a 10% penalty for early distribution if you are under age 59 ½.
• Lump sum. Take a taxable lump sum distribution. As with the lifetime or five-year distribution options, a lump sum distribution to you is subject to income tax, but a 10% penalty for early distribution prior to age 59 ½ does not apply.

Non-spousal beneficiary of traditional IRA

If you are named as the beneficiary of an IRA from a parent, grandparent, sibling, aunt/uncle, friend, etc. (aka anyone you weren’t married to when they died) then the rules are different – you may not treat the inherited funds as your own. However, the other options available to a spouse are also available to a non-spouse. A non-spouse traditional IRA beneficiary may:

• Open an inherited IRA in the deceased’s name, transfer the inherited assets into it, and take annual distributions over your lifetime. These distributions must begin no later than December 31 of the year following the account holder’s death. These lifetime distributions are taxable, but they are not subject to a 10% penalty for early distribution if you are under age 59 ½.
• Instead, you may elect taxable distributions of the full amount over a five-year period without incurring a 10% penalty for distributions received prior to turning age 59 ½.
• Finally, you could also take a taxable lump sum distribution immediately and without paying a 10% early withdrawal penalty if you’re under age 59 ½.

Spousal beneficiary of a Roth IRA

• Treat the inherited Roth IRA as your own, including rolling it into a new or existing Roth IRA.
• Elect lifetime tax-free distributions.
• Elect tax-free distributions of the full amount over a five-year period. However, if the account is less than five years old when distributions occur, earnings will be taxable.
• Take a lump sum distribution. However, if the Roth IRA was less than five years old at the time of the owner’s death, earnings are taxable when distributed.

Non-spousal beneficiary of a Roth IRA

With the exception of treating the inherited Roth IRA as your own (not an option in this instance), a non-spouse beneficiary of a Roth IRA has the same remaining options as does a spousal beneficiary:

• Elect lifetime tax-free distributions.
• Elect tax-free distributions of the full amount over a five-year period. However, if the account is less than five years old, earnings will be taxable.
• Take a lump sum distribution. However, if the Roth IRA was less than five years old, earnings are taxable when distributed

Inheriting an IRA is, of course, a bittersweet occasion where we have to simultaneously deal with the physical and emotional loss of someone we care about and also face some critical financial decisions. For more information and details regarding this important topic, refer to IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs). You might also want to consult with a qualified financial or tax advisor for advice on your particular situation.