When someone passes on, especially if it happens suddenly or unexpectedly, you’re likely not focused on the tax implications. But if you’ve inherited an IRA, there are steps you may need to take. Governing bodies like the IRS and recent legislation such as the SECURE Act have set important rules, such as whether you will need to begin taking Required Minimum Distributions (RMDs), how to calculate them, and how the distributions are taxed.
Mistakes can be costly, in the form of tax penalties or increased tax liability.1 Receiving your inherited IRA in a tax-efficient and meaningful way can depend on making well-informed decisions, either on your own or working with a trusted financial professional.
Here's an overview of some issues surrounding inherited IRAs.
Many Factors Affect Distributions
You may have questions about how and when you’re able to withdraw money from the account. The first point to understand is that you may take money from the inherited account whenever you want, but there are typically tax consequences with every distribution. The greater concern usually is that tax law and IRS rules require you to take at least a minimum distribution every year, potentially imposing tax liability you’d rather avoid. The rules consider several factors, including age, account type, and relationship to the decedent.
The rules, which can be quite complex, impose different requirements if the account holder died before versus after the age of 72, or in some cases, 70½ (at which time the IRS would have required them to take minimum withdrawals from a traditional IRA). Your own obligation to take a distribution doesn’t begin until the year after the decedent’s death. But if the original account owner didn’t take out all that was required in the year of their passing, that amount needs to be distributed by December 31 of that year.
The age of 59½ is also crucial, especially for surviving spouses who decide to transfer the account balance into their own IRA accounts (or to treat it as their own—see below) and subsequently withdraw the funds.2 In that case, any withdrawal before age 59½ would be subject to a 10% tax penalty; it might be better, depending on your circumstances, to treat the account as an inherited IRA, not as your own.
Another factor that influences distribution details is whether you inherit a traditional or Roth IRA. Under the SECURE Act3, non-spouse beneficiaries of an IRA (Roth or traditional) who are more than 10 years younger than the decedent are usually required to withdraw the entirety of the account within 10 years.
If you inherit a Roth IRA, you don’t pay taxes on distributions the way you would if you inherited a traditional IRA.
Non-Spousal Beneficiary of an IRA
Regardless of your age, you will need to begin taking RMDs by December 31 of the year following the original owner’s death. Unlike with your own IRA, you will not incur a penalty for taking money out before age 59½, though you will owe tax. (Also unlike your own IRA, you will not be able to make new contributions to an Inherited IRA.)
Under the SECURE Act, if the deceased passed on or after January 1, 2020, most non-spousal beneficiaries are required to withdraw the entirety of the account within 10 years, creating significant tax obligations for those inheriting substantial accounts. Exceptions to this rule include those who are:
- Disabled or chronically ill
- Minor children of the decedent
- Less than 10 years younger than the decedent
For the account to be treated this way you may not transfer the money into an existing account of your own. Instead, you will have to move your portion of the assets into a new IRA that is set up and named as an inherited IRA. Additionally, no additional (non-inherited) contributions are allowed in the new inherited IRA account.
Spouse Beneficiary of an IRA
If you are the surviving spouse, you will be faced with three options when inheriting an IRA.
You could remove the money from the account and spend or invest it as you see fit. If you inherit a large traditional IRA, this may incur significant tax bills. If you inherit a Roth IRA, electing this option will mean giving up the tax-advantaged status.
You may treat the account as your own IRA, either by designating yourself as the account owner or by rolling over into your own IRA or a retirement plan like a 401(k). This option is only available if you are the sole beneficiary of the account. While this is a popular choice, it may not be suitable for those who want to take money out before they reach the age of 59½.
You may prefer to treat the account as an inherited IRA. For example, if you are not yet 59½, transferring your deceased spouse’s IRA to your own retirement account would subject withdrawals to a 10% IRS penalty in addition to regular income tax.4 If, instead, you treat it as an inherited IRA, will have to take RMDs every year, but will not be subject to the 10% penalty.
Familiarizing yourself with the tax obligations of inheriting an IRA can help you not only with accounts you inherit, but can also help your loved ones to better prepare to receive your accounts at your passing. If you find yourself wondering whether you’re making the most effective decision for yourself and your family, we encourage you to enlist the help of a trusted financial professional who is familiar with the changing regulations and tax obligations regarding inherited IRAs.