Inherited IRA rules for beneficiaries

It’s never easy to lose someone. And, unfortunately, it’s often necessary to address financial matters simultaneously with the emotional stress of your loss.

Some common financial concerns include executing the will, as well as reviewing other aspects of their estate plan and inheritance. For listed beneficiaries, inheriting assets such as Individual Retirement Accounts (IRA) can be a unique challenge because of complex rules and potential tax implications.

What is an inherited IRA?

Also sometimes called a beneficiary IRA, an inherited IRA is an account that is opened when someone inherits an IRA after the original owner dies. The beneficiary may be anyone — a spouse, relative, or an estate or trust, for example.

How does an inherited IRA work?

Any type of IRA can be opened as an inherited IRA. This includes both traditional and Roth IRAs as well as rollover IRAs, SEP-IRAs and simple IRAs. Employer-sponsored retirement plans, including 401(k) and 403(b) plans can also be opened as inherited IRAs.

When an IRA owner dies, the assets held in their account generally must be transferred into a new IRA in the beneficiary’s name. This becomes an inherited IRA. Note that additional contributions cannot be made to an inherited IRA.

Regardless of what type of IRA is being inherited, inherited IRAs are all treated the same way. However, the tax treatment of inherited IRAs will differ based on what type of IRA it originally was (e.g., was it funded with pre-tax or post-tax dollars?).

The IRS provides detailed guidance to help inherited IRA beneficiaries. You must file IRS Forms 1099-R and 5498 to report an inherited IRA and its distributions for tax purposes.¹

What to do with an inherited IRA

If you are a beneficiary for an inherited IRA, your first instinct may be to simply collect the funds within the IRA by taking a lump sum distribution. But that may cause you to increase your taxable income, and ultimately sacrifice potential tax-deferred growth.

Depending on who the IRA belonged to (a spouse or non-spouse) and if you’re inheriting a traditional or Roth IRA, different inheritance rules may apply. It’s always a good idea to discuss inherited IRAs with a fiduciary financial professional, as every situation is unique.

Traditional IRA: Spouse inherited guidelines

If you inherit your spouse’s traditional IRA, you can assume ownership of the IRA by a spousal transfer. You can treat the IRA as if it was your own retirement account by naming yourself as the owner of the IRA.

As the beneficiary, you can also rollover the deceased’s IRA into a qualified employer plan, qualified annuity plan, tax-sheltered annuity plan, or deferred compensation plan of a state or local government such as a 457(b). An advantage of rolling over the deceased’s IRA into your own qualified retirement plan is the ability to defer Required Minimum Distributions (RMDs) of the funds in a traditional IRA until you reach the age of 72, 70½ if you reach 70½ before January 1, 2020. If you do roll over the funds into a qualified plan or your own IRA and take a distribution before the age of 59½, then you will likely be subject to a 10% early withdrawal penalty.

Consider all your options and their features and fees before moving money between accounts.

According to the IRS, it’s also important to note that if a surviving spouse receives a distribution from their deceased spouse’s IRA, that distribution can be rolled over into an IRA of the surviving spouse within a 60-day time limit as long as the distribution is not a required distribution.¹ This applies even if the surviving spouse is not the sole beneficiary of their deceased spouse’s IRA.

Roth IRA: Spouse inherited guidelines

If you inherit your spouse’s Roth IRA, you can also assume ownership of the IRA by a spousal transfer. The money will be available to you at any time, but the earnings will generally be taxable until you reach age 59½ and meet the five-year holding period. Note that this option is only available if you are the sole beneficiary of the IRA.

In addition to a spousal transfer, you can also open an inherited Roth IRA using the life expectancy method or the 10-year method. With the former, RMDs will be mandatory. However, you can postpone these distributions until the later of two options:

1. When your spouse would have turned 72, 70½ if the spouse reached 70½ before January 1, 2020.

2. The end of the year following your spouse’s death

With the latter, the money will be available at any time until the end of the tenth year after the year when your spouse died. At this time all the money must be distributed. With the 10-year method, provided that the five-year holding period has been met, distributions may be taken during that period without being taxed, and you will not incur the 10% early withdrawal penalty.

A final option is to distribute the Roth IRA in entirety via a lump-sum distribution. This option wouldn’t require establishing an Inherited IRA, and all assets will be distributed to you immediately. Earnings will be taxable if the account was less than five years old when your spouse died.

Traditional IRA: non-spousal inherited guidelines

If you inherit a traditional IRA from someone other than your spouse and are an eligible designated beneficiary, your withdrawal options are dependent upon the decedent’s age at death.

If the person was under age 72 when they died, your withdrawal options are to:

• Open an inherited IRA using the life expectancy method
• Open an inherited IRA using the 10-year method
• Take a lump sum distribution

If the deceased was 72 years of age or over, your withdrawal options are limited to:

• Open an inherited IRA using the life expectancy method
• Take a lump-sum distribution

To be considered a non-spouse eligible designated beneficiary, you must be:

• A minor child of the deceased account holder.
• Chronically ill or disabled.
• Not more than 10 years younger than the deceased beneficiary.

Roth IRA: non-spousal inherited guidelines

If you inherit a Roth IRA from someone other than your spouse and are an eligible designated beneficiary, you can open an inherited IRA using the life expectancy method, the 10-year method or a lump sum distribution.

Inherited IRAs for non-spouse beneficiaries, designated beneficiaries

The SECURE Act included new guidelines for non-spouse beneficiaries and inherited IRAs. Non-spouse beneficiaries can take a lump sum distribution, but as noted earlier, that will lead to potentially more taxable income.

Unlike spousal beneficiaries, non-spouses must establish an inherited IRA as the IRS does not allow you to roll over the money from the deceased IRA into your own retirement account or contribute funds to the deceased’s IRA.

For IRAs inherited after 2019, the SECURE Act mandates that non-spouse beneficiaries will need to distribute the Inherited IRA within 10 years of the original owner’s death. Those who are disabled, chronically ill, or within 10 years of age of the deceased individual may be exempt from this withdrawal guideline. In addition, minor children who are direct descendants of the deceased can be exempt from the rule until they are deemed age of majority by their state of residency.

It is important to understand that there are no annual requirements on your distributions, as long as the entire amount of funds is distributed within 10 years. If you fail to complete this 10-year requirement, you may be subject to a 50% penalty.

Depending on if you inherit a Traditional or Roth IRA, it may make sense to adjust the timeline of how you distribute the funds within the 10-year requirement. For a traditional IRA, it could be beneficial to take distributions each year to avoid having to take out a large lump sum in one particular year. If you take a large sum at once, this may push your taxable income into a higher tax bracket. On the other hand, if you inherit a Roth IRA, it may make sense to leave the funds within the Inherited IRA for as long as you can. By leaving the funds in the Inherited IRA, the account can potentially grow tax-free as you will not have to pay taxes when the funds are distributed from a Roth IRA.

Non-designated beneficiaries

Inheriting an IRA does not always come by way of listed beneficiaries, as IRAs can also be passed down through an established estate. The distribution method used for inheritors through estates will likely follow the old rules from before the SECURE Act.

The following actions are likely to be used to distribute the assets in the IRA:

• Disclaim the inherited retirement account and pass it along to a different person
• Take a lump sum distribution
• Distribute the assets within five years (there is no annual RMD requirement) if the original account owner died before their RMD age

How is an inherited IRA taxed?

The tax treatment of inherited IRAs depends on the type of IRA owned by the deceased as well as the type of beneficiary and withdrawal method selected. We recommend you talk with your tax advisor or CPA before deciding how to proceed. They can help you understand the specific tax implications of your inheritance and set up an appropriate distribution schedule to avoid tax penalties.

Next steps for you

If you are a beneficiary and inherit an IRA, it’s important that you get a complete understanding of your options, and the potential outcomes of each available option for you and the inherited IRA. Consider working with a fiduciary financial professional and/or an estate professional to assess the best course of action. Consulting a professional will help you avoid any nasty surprises in the form of penalties or taxes.