By Jamie Cattanach • Updated on March 7, 2023
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.
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.
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must be rolled into an inherited traditional IRA, while a Roth IRA (in which funds are taxed before contribution and withdrawn tax-free when you reach age for retiring) must be rolled into an inherited Roth IRA.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:
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:
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.
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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:
As always, if you have specific questions, reach out to a qualified tax advisor.
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 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.
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.