Some people are lucky enough to receive a windfall when they die, and it may come in the form of an inherited IRA. While receiving an inheritance is exciting, it could also have multiple tax implications. Understanding the rules around inherited IRAs can help recipients and people planning to give an IRA to a loved one upon their passing.
What is an Inherited IRA?
An inherited IRA is an individual retirement account opened by the beneficiary of an IRA or workplace retirement plan. When an IRA is inherited, it can’t be left in the deceased’s account, so an inherited IRA must be opened. Note that the account must be opened in the original account owner’s name, and new funds can’t be contributed. Inherited IRAs and any distributions must be reported to the IRS using forms 1099-R and 5498.
The types of accounts that can be transferred to an inherited IRA include traditional IRAs, Roth IRAs, 401(k)s, SIMPLE, and SEP IRAs.
How to Manage an Inherited IRA
Inherited IRAs can get complicated quickly. There are multiple options a beneficiary has when they receive one, which include taking a lump sum payment, turning down the IRA, or rolling funds into a personal IRA.
Lump Sum Payments
When an inherited IRA is established, one option is to receive a lump sum payment. This provides immediate access to the funds, which can be helpful for people who want to use the funds for an investment, to pay bills, or to assist with any other financial goals.
There are disadvantages to taking a lump sum, and the biggest one may be the tax liability. For instance, if one inherited $500,000 and took that in a lump sum, that distribution could push them into a higher tax bracket and result in a robust tax bill. The tax liability could also significantly reduce the inheritance amount.
Opening An Inherited IRA
As mentioned, opening an inherited IRA is a mandatory first step. The benefit of an inherited IRA is that once funds are rolled over, they can grow in the IRA tax-deferred in the case of traditional IRAs and tax-free in the case of inherited Roths. Beneficiaries can also withdraw funds whenever they need from either IRA.
For both Roth and traditional IRAs, beneficiaries have ten years to deplete the funds, beginning the year after the original account owner dies.
The main options for the frequency of these distributions include annual distributions, taking distributions as often as you want but by the end of a set date, or a combination of both. The option beneficiaries choose depends on when the account holder died.
To open an inherited IRA, beneficiaries need paperwork verifying their right to the account and a death certificate.
Refuse the Inheritance
Turning down an IRA is an option some beneficiaries may opt for. Some reasons to turn down an inherited IRA include wanting to give it to the next beneficiary in line, feeling like the tax implications aren’t worthwhile, or for personal reasons. If a beneficiary does turn an inherited IRA, they can’t determine where the assets go.
Beneficiaries must turn down an inheritance within a timeframe, which is usually within nine months of the account owner’s passing or nine months after the beneficiary turns 21.
Rollover Into a Personal Account
This option is only available for spouses. Funds can be rolled into an existing IRA, or spouses can open a new account. Note that IRA withdrawal penalties and distribution rules are the same even when funds are rolled over. That means penalties still apply for withdrawals on contributions made before 59 ½ . Spouses also have the option of putting the inherited IRA in their name and treating the IRA as their own if they’re the sole beneficiary.
Inherited IRA Rules
There are multiple rules around inherited IRAs, and it’s critical to know them to avoid penalties. The type of IRA inherited–Roth or traditional-affects the tax and RMD treatment of the account.
Taxes
Withdrawals from traditional inherited IRAs are taxable. However, contributions withdrawn from Roth IRAs are tax-free. Withdrawing earnings from a Roth is tax-free only if the account was open for at least five years after the account holder passed.
Exceptions to the 10-year rule
As mentioned, most beneficiaries must withdraw all funds from an inherited IRA within ten years. However, eligible designated beneficiaries are exempt from this rule. That includes:
- Spouses: Since they can treat the account like their own, spouses aren’t subject to the 10-year rule. However, RMDs are required on traditional IRAs, with the timing dependent on when the account owner died and which option the spouse chooses for managing the inherited IRA.
- Minors: Individuals don’t have to worry about the 10-year rule until they clock 18 or the age of majority, which varies between states. At that point, the 10 year rule applies.
- Inherited IRA before 2019: People who inherited an IRA from someone who died before December 31, 2019, aren’t subject to the 10-year rule and can stretch withdrawals throughout their lifetime.
- Chronically ill or disabled: This group of individuals can also withdraw money from the IRA throughout their lifetime
- Those not over 10 years younger than the original account owner
Required Minimum Distributions
All inherited IRAs are subject to RMDs, whether traditional or Roth accounts . Some beneficiaries of IRAs have to follow an RMD schedule based on when the account owner died. For account owners who died on or after January 1, 2020, this may especially be true thanks to the SECURE Act 2.0.
Factors that impact distributions from an inherited IRA include the beneficiary’s relationship to the account holder, whether the original account owner died before or after their required beginning date for RMDs and what year the original account owner died.
For account owners who died before 2020, the rules are different and can be complex, so speaking to a finance professional can help. RMD calculators can also help better understand distribution rules and amounts.
