If you inherited an IRA, that windfall may cost you money if you aren’t careful. That’s because there are rules around inherited IRAs to ensure the money in the account is eventually taxed and the IRS gets paid.
Run afoul of any of the rules and you may create a costly tax event, plus you can be hit with fees and penalties.
“There is no downside to inheriting an IRA other than not being able to handle it,” says Ed Slott, president of Ed Slott & Co., an IRA distribution firm in New York. “I’ve worked with parents and grandparents who don’t talk to their kids about inheritance. The kids get a windfall but don’t realize it’s taxable.”
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What is an inherited IRA?
An inherited IRA, sometimes referred to as a beneficiary IRA, is created when an IRA is passed on to a spouse, family member or loved one when the account holder passes away.
You can bequeath an IRA to anyone but there are different rules depending on the beneficiary.
Assets in the original IRA must be transferred into an inherited IRA in the beneficiary’s name. Additional contributions cannot be made to the inherited IRA but the funds remain tax-deferred.
f you are a non-spouse beneficiary, you are required to liquidate the entire account by the 10th year of the account holder’s death. That’s where it gets tricky and potentially costly, given the distribution is treated as ordinary income.
“Non-spouse children or grandchildren have to empty the account at the end of the 10th year after death,” says Slott. “That’s a big tax hit in year ten” if you do nothing.
Inherited IRA rules
Thanks to the The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, IRA accounts inherited by non-spouses after December 31, 2019 are subject to the ten year rule.
There are some exemptions. If the beneficiary’s age is within ten years of the deceased, is disabled or chronically ill or a minor child of the deceased, then the old rules apply. You can withdraw the money for as long as you want.
If the deceased had already begun making required minimum distributions (RMDs), which kick in at age 73, the new IRA beneficiary must continue to do so during the ten year period. Drawdowns are recalculated based on your life expectancy.
You can leave an IRA to anyone but tax rules favor the spouse. “Spouses have the most flexibility when inheriting assets,” says Sham Ganglani, retirement distributions leader at Fidelity Investments. “They are the only ones that can treat the money as their own.”
If you receive an IRA from your deceased spouse you have several options:
-Take over the account. You become the account holder of the IRA via a spousal transfer. The money is accessible immediately but any distributions are taxable.
If you are under age 59-1/2 there may be penalties unless you meet certain exceptions.
RMDs are based on your age, not the age of the deceased account holder, and therefore can be spread out over a greater number of years if you are younger. This can help lower the potential tax hit.
-Open an inherited IRA. You can roll the assets into an inherited IRA. RMDs are required based on your life expectancy and you have to empty the account by the tenth year. This may be beneficial for spouses under the age of 59-1/2 who need access to the money.
-Take a lump sum. You can take a lump sum distribution but the money will be treated as ordinary income. Keep in mind the cash out could push you into a higher tax bracket which means more income taxes due.
Rules for non-spouses inheriting an IRA
For non-spousal beneficiaries who don’t meet the exemptions, the rules are less flexible and options are limited to the following:
-Open an inherited IRA. RMDs are based on your life expectancy and the ten-year rule applies. Assets continue to grow tax-deferred.
-Cash out. You’ll pay taxes on a lump sum distribution and could also push you up into a higher tax bracket.
Inheriting a Roth IRA
If you inherit a Roth IRA the same rules apply but there is one benefit: you don’t have to pay taxes on any withdrawals because it's funded with after-tax dollars. Plus the account grows tax-free.
There are caveats for tax-free distributions: The original Roth IRA has to have been funded for five or more years and any assets withdrawn from converted balances has to have been in the account for five years at a minimum.
While the original owner does not have to worry about RMDs, you do. But it’s not in the traditional sense. You just have to make sure the account is emptied within ten years of the original owner’s death if you are a non-spouse.
If you are inheriting the Roth IRA from a spouse, you can treat the Roth IRA as your own and take distributions over your lifetime.
Spread it out to save on taxes
When it comes to handling inherited IRA requirements, financial advisers say spreading withdrawals out over several years is the best way to lower the tax implications.
The beauty of an inherited IRA is you can withdraw more if you need it one year and less another year without facing a penalty. “Try to avoid picking a lump sum,” says Ganglani. “That’s a tax consideration many people don’t think about.”
Once you have the inherited IRA, don't let loyalty keep you from making changes to the holdings within the account. They may have worked for your benefactor, but they may not be the best investment for your goals.
“If those investments you inherited don’t align with your risk and your objectives for saving and growing assets, don’t be afraid to reallocate them,” Ganglani says. “Don’t think this is dad’s IRA.”
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