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. 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.

What is an inherited IRA?

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.

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.

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:

• 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 an inherited IRA, or cash it out.
• When you inherit an IRA or 401(k) from a non-spouse: you can set up an inherited IRA or cash it out.

When can you take a distribution from an inherited IRA?

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:

• 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 contributions and you’ll have to start withdrawing money at age 72 for traditional IRAs — but you are not required to make withdrawals from a Roth IRA at any time. However, if you opened an inherited IRA, you’ll need to start taking withdrawals based on the original owner’s distribution schedule. So, if the owner was 72 or older, you’ll have to take withdrawals from the start. This applies to both Traditional and Roth IRAs. Choosing which option is best for you will depend on your age and how soon you’d like to start making withdrawals.
• 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. You can take out the money in whatever amounts you choose so long as the entire IRA is depleted after ten years. This is generally called the 10-year rule. Note: if the deceased died before January 1, 2020, you must deplete the balance within 5 years.
• There are some exceptions to the 10-year rule. For minors, the 10-year clock doesn’t usually start until they reach the age of 18. Chronically ill and disabled beneficiaries can take withdrawals from the inherited IRA over the course of their lifetimes. Finally, if you are less than 10 years younger than the original IRA account holder, you can choose to take withdrawals over the course of your lifetime.

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: You’ll pay taxes on withdrawals 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, the 10% penalty for withdrawals before age 59 ½ doesn’t apply.
• For Roth IRAs inherited by spouses and non-spouses: 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.

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 account holder 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 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.

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, 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.