An inherited IRA is an account opened posthumously when you inherit an IRA or employer-sponsored retirement plan from its deceased original owner. The beneficiary could be a spouse, relative, unrelated individual, or even an estate or trust. Specific rules differ for spousal and non-spousal beneficiaries. This guide helps you understand everything about inherited IRAs.
Key Takeaways
- An inherited IRA, also referred to as a beneficiary IRA, is an account created when you inherit an IRA after the original owner’s passing.
- Additional contributions cannot be made to an inherited IRA.
- Withdrawal rules vary significantly between spousal and non-spousal beneficiaries.
- Non-spousal beneficiaries must withdraw the total funds from inherited IRAs within 10 years, per the SECURE Act.
- Traditional IRA owners must start taking required minimum distributions (RMDs) beginning at age 73.
How an Inherited IRA Works
Beneficiary IRAs are created using assets from any type of IRA, including traditional, Roth, rollover, SEP, and SIMPLE IRAs. Assets held in the deceased individual’s IRA are generally transferred into a new inherited IRA set up in the beneficiary’s name. This mandatory transfer applies even if a lump-sum distribution is planned.
Tax laws surrounding inherited IRAs are detailed and nuanced, particularly after the updates from the SECURE Act of 2019, which brought significant changes, especially affecting non-spouse heirs.
Inherited IRAs are treated similarly irrespective of being traditional or Roth. Nonetheless, the tax treatment of withdrawals aligns with the type of IRA - pre-tax for traditional and post-tax for Roth IRAs.
Inherited IRAs: Rules for Spouses
Spouses have greater flexibility in managing an inherited IRA. They can either roll the IRA into their existing individual retirement accounts or maintain it as a separate inherited IRA.
Benefits of Rolling Over to Own IRA
- Defer Required Minimum Distributions (RMDs): Spouses can defer RMDs until age 73, offering more prolonged tax benefits.
- 60-Day Rollover Window: They have 60 days from receiving a distribution to roll it over into their own IRAs as long as the distribution is not a required minimum distribution (RMD).
If the original IRA owner had begun taking RMDs, the spousal beneficiary must continue or submit a new schedule based on their life expectancy. If the original owner had not started RMDs, the spouse has a five-year window to withdraw the full amount.
Inherited IRAs: Rules for Non-Spouses
Non-spouse beneficiaries cannot treat the inherited IRA as their own. Additional contributions and transfers to existing personal IRAs are out-of-the-question. New inherited IRA accounts must be set up unless an immediate lump-sum distribution is opted for.
The SECURE Act mandates that non-spouse beneficiaries cash out the inherited IRA within ten years after the IRA owner’s passing, with certain exceptions. However, Roth IRA funds remain tax-free, and penalties on early withdrawals are not applicable even if the heir is under 59½.
Exceptions to the 10-Year Rule
- Those within ten years of age of the deceased.
- Disabled or chronically ill individuals.
- Minor children must utilize the funds before the 10-year rule starts once they reach the age of majority.
Your Options for Receiving Benefits
IRA beneficiaries’ choices for claiming inheritance heavily depend on their relationship with the decedent. Options include lump-sum distributions, disclaiming the inheritance, and leaving the assets in the current plan.
For Spouses:
- Take a lump-sum distribution, subject to taxes.
- Roll over inherited funds into a personal IRA.
- Establish an inherited IRA, adhering to RMD rules based on the decedent’s age.
- Disclaim the inheritance, transferring rights to other beneficiaries or the estate.
For Non-Spouses:
- Take funds as a taxable lump-sum distribution.
- Disclaim the inheritance to transfer rights.
- Transfer the assets into an own inherited IRA and meet RMD obligations based on their age or under the SECURE Act’s 10-year rule for deaths post-January 1, 2020.
Frequently Asked Questions (FAQs)
Do Beneficiaries Pay Taxes on Inherited IRAs?
It depends. Roth IRA inheritances are generally tax-free, while traditional IRA distributions are typically taxed. Estates subject to estate tax may also offset some of this charge to the beneficiary through an income-tax deduction.
What Happens When You Inherit an IRA From a Parent?
If the inheritor is a minor, a custodian will manage the IRA until they reach adulthood. Upon hitting this age, they gain full access, able to make withdrawals which may still be taxable.
How Do I Avoid Paying Taxes on an Inherited IRA?
Strategic planning before the original owner’s death, like converting a traditional IRA to a Roth IRA, can help minimize tax burdens. Beneficiaries should avoid non-qualified distributions to sidestep taxation.
The Bottom Line
Both traditional and Roth IRAs are crucial for retirement planning. With inherited IRAs, Roth IRAs often provide better tax avoidance options compared to traditional IRAs, which are subject to more stringent distribution rules and higher RMD requirements. Understand these differences to maximize the financial benefit from your inheritance.
Related Terms: Roth IRA, Traditional IRA, RMD, SECURE Act, Estate Planning.
References
- Internal Revenue Service. “Retirement Topics - Beneficiary”.
- United States Congress. “H.R. 2617”.
- IRS. “Publication 590-B”,
