Inherited an IRA? Avoid These Expensive Mistakes

If you inherited an IRA, that windfall may cost you money if you aren’t careful. That’s because there are rules surrounding inherited IRAs to ensure the money is eventually taxed and the IRS is paid.

Run afoul of any of the rules and you may create a costly tax event or worse, face 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.

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“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.”

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.

Regardless of who receives the inherited IRA, two rules apply:

• Assets in the original IRA must be transferred into an inherited IRA in the beneficiary’s name.
• Additional contributions can't be made to the inherited IRA.

The funds remain tax-deferred as long as they are in the account.

Spousal vs. Non-Spousal Beneficiary Options At a Glance

Spousal vs. Non-Spousal Beneficiary Options At a Glance

Rules for spouses inheriting an IRA

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:

1. 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.

Required Minimum Distributions 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.

2. 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.

3. Take a lump sum. You can take a lump sum distribution, but the money will be treated as ordinary income. Keep in mind the withdrawal could push you into a higher income bracket, which means more taxes.

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:

1. Open an inherited IRA. Required Minimum Distributions (RMD) for non-spousal beneficiaries are based on life expectancy, and the ten-year rule applies. Assets continue to grow tax-deferred.

2. Cash out. You can take a lump sum and close the account, but there are tax consequences. If it's a traditional IRA, the money will be treated as ordinary income. Plus, it may push you into a higher income bracket, increasing your tax burden.

Watch out for the ten-year rule thanks to the SECURE Act

Non-spouse beneficiaries and spouses opening an inherited IRA need to be mindful of the ten-year rule, which requires beneficiaries to liquidate the account by the 10th year of the account holder’s death.

That’s where people get in trouble if they haven't spread out withdrawals over the years.

“That’s a big tax hit in year ten,” if you do nothing, says Slott.

Thanks to the SECURE 2.0 Act, 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 is 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 years. Drawdowns are recalculated based on your life expectancy.

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 have 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 that 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.

“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.”

Disclaiming the inheritance, the better option?

For some people, disclaiming an inherited IRA is the better option. That’s particularly true if they are trying to avoid a tax hit, disqualifying from a benefit, or want the asset to go to someone else.

Whatever the reason, there is only a short window — typically nine months from the account owner's death — to disclaim the inheritance.

Disclaiming an inherited IRA is complex and requires you to seek professional advice. Keep in mind that once you do it, it's irrevocable. It can’t be changed. The inherited IRA automatically passes to the next-in-line beneficiary.

Follow all the rules when inheriting an IRA

Inheriting an IRA can be a boon to your retirement savings, but you have to be mindful of the rules.

Whether you are a spouse or non-spouse beneficiary, make sure to open the proper account, make tax-smart withdrawals, and seek help when you need it.

You don’t want what was intended to be a financial windfall to turn out to be a costly mistake.

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