Inherited IRAs: Rules, Taxes and More

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 (Individual Retirement Account). Dealing with estate planning 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 personal finance decisions and avoid a surprise at tax time.

What is an inherited IRA?

An inherited IRA is a type of retirement account opened for someone who inherits a deceased person’s IRA or 401(k), most often as spousal beneficiaries. These accounts are also known at some brokerages as IRA BDAs, short for IRA Beneficiary Distribution Account.

Importantly, inherited IRA rules change depending on whether the original account owner was your spouse or someone else. Either way, you’ll have some decisions to make — and there are important tax implications to understand for each scenario.

What are the rules for an inherited IRA?

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 distribution.

However, there’s one major difference: if you, as a surviving spouse, 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 (in which funds grow tax-deferred) must be rolled into an inherited traditional IRA, while a Roth IRA (in which funds are taxed before contribution and withdrawn tax-free when you reach age for retiring) must be rolled into an inherited Roth IRA.

If the beneficiary inherits a retirement 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 specific situation:

• When you inherit an IRA or 401(k) from a spouse: you can roll it into your existing IRA and treat it as your own, set up a separate inherited IRA, or cash it out.
• When you inherit an IRA or 401(k) from a non-spouse: you can set up a new account as an inherited IRA or cash it out as a sole beneficiary.

When can you take a distribution from an inherited IRA?

Understanding your distribution options when it comes to inheriting an IRA is an important part of financial planning. 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, as well as whether or not the original account holder had reached the age at which they were required to take RMDs in the first place.

Here’s the breakdown of inherited IRA distribution rules:

• For IRAs inherited from spouses: If you’ve rolled the inherited IRA into your own account, the IRA will be treated as if it’s yours. You’ll still be able to make additional contributions. If you have a traditional IRA, you’ll have RMDs as you would have otherwise, beginning at age 73 — though if your spouse had already reached the required beginning date to take RMDs, you’ll need to take an RMD for the year of death if they did not already take it. Fortunately, you’re not required to make withdrawals from a Roth IRA during your lifetime.
  • However, if you opened a separate inherited IRA, you have a few options:
    • The life expectancy method. If the decedent hadn’t yet started taking RMDs yet, you can wait to take RMDs until the year in which the decedent would have turned age 73. If the decedent was already taking RMDs, you can take them based on your life expectancy, but beginning no later than 12/31 the year after the original account holder’s death.
    • Adhere to the 10-year rule. If the decedent hadn’t yet started taking RMDs yet, you’ll need to liquidate the account by 12/31 of the tenth year after the decedent died. If the decedent was already taking RMDs, the 10-year rule won’t apply to you.
• For IRAs inherited from non-spouses: In most cases, you’ll be required to begin taking withdrawals within a year of the original owner’s death. In addition, the entire balance must be depleted within 10 years. If the original account holder had not yet been required to take RMDs, you can take out the money in whatever amounts you choose so long as the entire IRA is depleted after ten years. If they had reached the required beginning date to take RMDs, you must continue to take RMDs over the 10-year period.

• The IRS offers some exceptions to the 10-year rule. These exceptions are related to those that the IRS has deemed “eligible designated beneficiaries.” Such beneficiaries include:
  • A minor child of the decedent
  • Chronically ill and permanently disabled beneficiaries
  • Those who are not more than 10 years younger than the original account holder.

Eligible designated beneficiaries can deplete their inherited accounts over their respective life expectancies, opt for the 10-year rule, or take a lump sum distribution.

How much tax will you pay on an inherited IRA?

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:

• For Traditional IRAs inherited from spouses: Money withdrawn from a new IRA is treated as normal, taxable income, and will be taxed at your regular income tax rate. If you’ve transferred the funds into your own IRA, the money is treated as if it were always yours — which means you’ll still be subject to an additional 10% penalty if you make withdrawals before the age of 59 ½. However, you won’t incur this penalty if you transfer the funds to a separate inherited IRA.
• For Traditional IRAs inherited from non-spouses: You’ll pay taxes on withdrawals from the inherited IRA at your regular income tax rate. Importantly, though, the 10% early withdrawal penalty for withdrawals before age 59 ½ doesn’t apply.
• For Roth IRAs inherited by both spouse and non-spouse beneficiaries: You won’t pay any taxes on your Roth IRA withdrawals since the original owner paid taxes when they contributed. However, the Roth IRA must be at least 5 years old to be eligible for tax-free withdrawals – this is called the 5-year rule. If the account is less than 5 years old, you will pay income taxes on the withdrawal.

As always, if you have specific questions, reach out to a qualified tax advisor.

What about lump-sum withdrawals?

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.

• Traditional IRA and 401(k) withdrawals are taxed as regular income. So, depending on how much money the original IRA owner had saved, taking a lump sum withdrawal could push you into a higher tax bracket.
• Roth IRA withdrawals, on the other hand, are tax-free. The 5-year rule still applies, though, so make sure to check how old the account is before opting for a lump sum payment.

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 distribution, 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 or trustee transfer 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.

Bottom line

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, which withdrawal rules apply, and how much long-term asset growth you stand to see. You’ll also want to consider your short- and long-term financial planning 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.