If you’ve recently lost a loved one and inherited their retirement account, you have some decisions to make about what to do with their IRA. Dealing with a retirement account during a time of personal loss can feel difficult, so we’ve created this guide to help you understand your options. Knowing the IRA beneficiary rules can help you make smart financial decisions and avoid a surprise at tax time.
An inherited IRA is a specific type of retirement account opened for someone who inherits a deceased person’s IRA or 401(k). These accounts are also known as IRA BDAs, short for IRA Beneficiary Distribution Account.
Importantly, inherited IRA rules change depending on whether you’ve inherited that account from a spouse or from someone else. Either way, you’ll have some decisions to make — and there are important tax implications to understand for each scenario.
There are different rules for inheriting an IRA from a spouse and from a non-spouse.
In both scenarios, you can set up an inherited IRA to transfer the inherited account into. You can also cash out the account in a lump sum.
However, there’s one major difference: if you inherit your spouse’s account, you can roll the funds into your existing IRA account and treat it as your own via a rollover. Just remember that the destination IRA must match the type of the original account — so a traditional IRA must be rolled into another traditional IRA and a Roth IRA must be rolled into a Roth IRA.
If you’re inheriting an account from a non-spouse, you have two options. You can set up an inherited IRA to transfer the account into or cash out the funds by taking a lump-sum withdrawal.
Before we continue, let’s recap your options in each scenario:
The timeline for when you’ll be able — or required— to take distributions from an inherited IRA depends on which of the options outlined above you choose.
In most cases, you’ll be subject to inherited IRA RMDs, or required minimum distributions. This means that you’ll be required to take withdrawals once a certain time threshold has passed. These rules apply to traditional and Roth IRAs, but change depending on who you inherited the account from and what you choose to do with the funds. Here’s the breakdown of inherited IRA distribution rules:
The taxes you pay on an inherited IRA also depend on whether you inherited it from a spouse or not, as well as the type of IRA you inherit:
If you decide to cash out the IRA all at once, you won’t have to worry about taking required withdrawals or setting up an inherited IRA. But you will be on the hook for what could be a hefty tax bill come April.
One piece of good news? Even if you’re under the age of 59 ½, you won’t have to worry about the 10% early withdrawal fee when you take a lump-sum withdrawal, regardless of who you inherit it from or the type of IRA.
Still, as attractive as the lump-sum might be, other options may suit your long-term financial needs better. No matter what kind of retirement account you’re talking about, a rollover is often a better idea than a withdrawal — especially because a rollover keeps your money invested which means your assets can continue to grow over time.
We understand that financial decisions will not be your first priority after the loss of a loved one. Once you’re ready, knowing the rules and options available to you when inheriting an IRA or 401(k) can make the process less complicated for your family. When deciding what to do, keep in mind how each option impacts your tax bill, withdrawal rules, and long term asset growth. You’ll also want to consider your short and long term financial needs, since your choices will impact how soon you can access the money. If you’re unsure which option is best for you, consider asking a financial advisor.