Saving for retirement is vitally important, and Individual Retirement Accounts (IRAs) play an essential role in helping Americans set aside money for their golden years. But did you know that you could come into an IRA if a loved one leaves theirs to you?

If you don't have your own IRA, you may be baffled if you inherit one, but don't fear. We'll walk you through everything you need to know about using an IRA bequeathed to you. 

Image source: Getty Images.

What is an IRA?

An IRA is a tax-advantaged investing account intended for saving for retirement. IRAs are self-directed, meaning you select your own investments once you fund the account. There are two types of IRAs, traditional and Roth, and this classification determines how the money gets taxed by the Internal Revenue Service (IRS). In addition to traditional and Roth IRAs, there are some specialized types of retirement accounts like SEP IRAs and SIMPLE IRAs, which are designed for use by those who are self-employed or own small businesses. 

There's more than $9.5 trillion invested in IRAs, according to the Investment Company Institute, and the accounts are increasingly popular, with assets rising at an average rate of 10% per year for the past quarter-century. About 42.6 million households use IRAs in their retirement financial planning.

Ideally, people save in an IRA throughout their careers and then spend down their IRA assets during their retirement. For a variety of reasons, though, some people aren't able to use up all of their IRA money before passing away. In that case, the IRA will go to their beneficiary, the person the original owner names. Then, it's up to the beneficiary to use the inherited account in the most optimal way.

There are numerous rules governing IRA inheritance, and knowing the ins and outs is crucial if you don't want to waste the opportunity you've been given as an heir. First, let's dig into the process of inheriting an IRA.

How does the IRA inheritance process work?

The most important thing in IRA inheritance happens long before any heir receives handed-down assets. When IRA owners open their accounts, they select beneficiaries, who are the named people who will receive the IRA assets upon the death of the account holder. Sometimes, an IRA owner will name a primary beneficiary as well as contingent beneficiaries. As long as the primary beneficiary is alive at the death of the account holder, then the IRA assets go to the primary beneficiary. Any contingent beneficiaries only receive assets from the IRA if the primary beneficiary has passed away, or chooses not to accept the assets. 

There's no limit on who you can name as an IRA beneficiary, but as you'd probably suspect, most beneficiaries are family members. For married people, naming a spouse as primary beneficiary is the most common arrangement, but siblings, children, parents, and other relatives also show up frequently on IRA beneficiary designation forms.

One key point is that for estate-planning purposes, your beneficiary designation controls who receives the IRA after your death, even if you give different instructions in your will or other estate-planning document. So, if you name one person as your IRA beneficiary, but someone else in your will, it's the beneficiary who'll get the IRA assets. 

What are the rules governing an IRA inheritance?

The rules governing IRA inheritances depend largely on two things: who the beneficiary is, and how old the original IRA owner was at the time of their death. Specifically, spousal beneficiaries have some options that other beneficiaries don't. Also, different options are available if the account owner hasn't been mandated by required minimum distributions (RMDs) to take withdrawals from their IRA, than if the account owner was old enough to start taking RMDs.

IRA beneficiaries have the following choices to comply with the distribution rules governing inherited IRAs:

  • They can take an immediate lump-sum distribution of the entire IRA account balance.
  • If the original owner wasn't yet required to take distributions from the IRA, then heirs can keep money in the account for up to five years after the owner's death.
  • They can take minimum annual withdrawals from the IRA over the course of their lifetime, as determined by their life expectancy defined by special IRS tables.
  • Spouse beneficiaries can roll over the original owner's IRA into their own IRA. Thereafter, the account will be treated as if the spouse beneficiary had always owned it, with the same rules governing withdrawals and other account aspects.

We'll give you the details and look at the pros and cons of each of these options below.

The simple choice for spouse beneficiaries

By far, the easiest way to handle an inherited IRA involving a spouse beneficiary is for the surviving spouse to take the inherited IRA and transfer it into an IRA in their own name. Doing so combines the surviving spouse's retirement assets into a single account, making it easier to invest and manage the assets according to a single unified financial plan. Moreover, with some IRA managers charging various types of account fees, consolidating multiple IRAs into a single account can save on costs as well.

There are three options for how spouse beneficiaries can complete an inherited IRA transfer into their own name: 

  1. The surviving spouse can keep the account with the same financial institution and ask to change the official title of the inherited IRA to be in the surviving spouse's own name.
  2. The surviving spouse can also arrange to have the account transferred to a different financial institution, either adding it to the surviving spouse's existing IRA or putting it into a new IRA.
  3. The surviving spouse can liquidate the inherited IRA and receive the assets for a brief period of time up to 60 days, and then deposit the assets into an existing or new IRA through what's called a rollover. 

However, there's one major downside to treating the inherited IRA as the spouse's own. If the surviving spouse is younger than age 59 1/2, then once all the money is in the surviving spouse's own IRA, subsequent distributions can be subject to the 10% penalty on early withdrawals. By contrast, there's never an early withdrawal penalty when you take money directly from an inherited IRA. So if the surviving spouse hasn't yet reached age 59 1/2 and anticipates needing to take money out of the IRA, then one of the below alternatives might yield better results.

Should you take a lump-sum withdrawal?

The IRS lets any beneficiary take a lump-sum withdrawal of the entire balance of the IRA. Taking the money and running, so to speak, is a tempting way to handle an IRA inheritance because it's quick and easy, but it's rarely the best move.

Taking an immediate withdrawal has negative tax consequences. For a traditional IRA, you'll have to include the entire value of the IRA as taxable income in the year that you take it. Depending on the size of the IRA, it can have a huge impact on your total tax, potentially even kicking you into a higher tax bracket and thereby paying a higher rate of tax on your inheritance. By contrast, if you don't take a lump sum, then whatever stays in the account can keep growing tax-deferred.

Even if you're receiving a Roth IRA inheritance, an immediate lump-sum withdrawal can be costly. That's because as long as the money stays inside the inherited Roth IRA, any income or gains on investments are tax-free. However, once the money's outside the Roth, then all bets are off, and you're subject to ordinary income tax rates on any and all withdrawals.

What is the five-year reprieve?

Because of the hefty tax consequences of taking a lump-sum distribution of an inherited IRA, many IRA beneficiaries put off withdrawing the full balance of their inheritance.

In cases where the original account holder wasn't yet subject to RMDs -- that is, for all inherited Roth IRAs and for traditional IRAs when the owner hadn't yet hit age 70 1/2 -- beneficiaries can elect to take out the full balance of the inherited IRA at any time over a five-year period.

The benefits of this method are that the beneficiary has full discretion on timing within the five years. Especially with a traditional IRA, spreading out the resulting tax liability over five separate tax years can keep you from jumping into new tax brackets. Alternatively, you can wait to take the full lump sum in the fifth year -- perhaps giving you enough time to arrange your affairs and do some tax planning to be able to deal with the big chunk of taxable money.

However, for many beneficiaries, five years is still a relatively short period of time. If you want to take full advantage of the opportunities that an IRA inheritance opens up for you, then the best option is the one that'll let the account last as long as possible.

What is a "stretch" IRA?

The smartest option that non-spouse beneficiaries have is to take distributions from their inherited IRA over the course of their entire lifetimes, defined by IRS life expectancy tables. This maximizes the ability of the beneficiary to stretch out their distributions as long as possible, which is why this option is often referred to as a "stretch IRA."

The primary benefit of using a stretch IRA is that it maximizes the amount of time that you can earn tax-deferred or tax-free income and gains from the retirement account. In addition, beneficiaries are able to take relatively small portions of the account as withdrawals each year, which minimizes the adverse tax consequences that can result from taking big distributions.

It's also important to note that the stretch IRA option doesn't limit your ability to take larger distributions from the inherited IRA. The stretch IRA rules only tell you the minimum amount that you're required to take out of the retirement account each year. It doesn't establish a maximum amount, so you're free to take out more than the minimum for any reason.

How do you calculate RMDs from a stretch IRA?

If you're going to use the stretch IRA method, you have to understand how to calculate its annual required minimum distributions (RMDs). The idea is that the IRS wants to make sure that you take out the entire balance of the inherited IRA over the course of your expected lifetime so it can get its tax cut. That's why you have to use the life expectancy tables that the IRS provides in order to calculate the correct amount of each annual withdrawal you take from your IRA inheritance.

Here's the three-step process you'll need to come up with each year's withdrawal amount:

  1. Take the value of your inherited IRA as of Dec. 31 of the previous year.
  2. Find the correct distribution factor, using the IRS table as well as your past records.
  3. Divide the total retirement account balance by the distribution factor.

The answer tells you the amount of each RMD if you use the stretch method for your inherited IRA.

For heirs, it's critical to use the right IRS table. Ignore the tables for original IRA holders and go straight to the table for inherited IRAs. A compact version is below.

How do I find my RMD for an inherited retirement account?

Age

Distribution Factor

Age

Distribution Factor

Age

Distribution Factor

Age

Distribution Factor

0

82.4

30

53.3

60

25.2

90

5.5

1

81.6

31

52.4

61

24.4

91

5.2

2

80.6

32

51.4

62

23.5

92

4.9

3

79.7

33

50.4

63

22.7

93

4.6

4

78.7

34

49.4

64

21.8

94

4.3

5

77.7

35

48.5

65

21.0

95

4.1

6

76.7

36

47.5

66

20.2

96

3.8

7

75.8

37

46.5

67

19.4

97

3.6

8

74.8

38

45.6

68

18.6

98

3.4

9

73.8

39

44.6

69

17.8

99

3.1

10

72.8

40

43.6

70

17.0

100

2.9

11

71.8

41

42.7

71

16.3

101

2.7

12

70.8

42

41.7

72

15.5

102

2.5

13

69.9

43

40.7

73

14.8

103

2.3

14

68.9

44

39.8

74

14.1

104

2.1

15

67.9

45

38.8

75

13.4

105

1.9

16

66.9

46

37.9

76

12.7

106

1.7

17

66.0

47

37.0

77

12.1

107

1.5

18

65.0

48

36.0

78

11.4

108

1.4

19

64.0

49

35.1

79

10.8

109

1.2

20

63.0

50

34.2

80

10.2

110

1.1

21

62.1

51

33.3

81

9.7

111+

1.0

22

61.1

52

32.3

82

9.1

   

23

60.1

53

31.4

83

8.6

   

24

59.1

54

30.5

84

8.1

   

25

58.2

55

29.6

85

7.6

   

26

57.2

56

28.7

86

7.1

   

27

56.2

57

27.9

87

6.7

   

28

55.3

58

27.0

88

6.3

   

29

54.3

59

26.1

89

5.9

   

Data source: IRS.

The chart's distribution factor essentially tells you how many years you're expected to live based on your current age. For instance, if you'll turn 48 this year, the IRS says your remaining life expectancy is 36.0 years. 

Here's an illustration: Say you'll turn 48 in 2019, and you inherited an IRA from a parent who passed away in 2018. As of Dec. 31, 2018, the inherited IRA was worth $90,000.

Using the three-step guide, you take the $90,000 value of the inherited IRA and divide it by the distribution factor for a 48-year-old, which is 36.0. $90,000 divided by 36.0 is $2,500, so that's how much you'll have to withdraw in 2019 to meet the stretch IRA requirements.

That's pretty simple, but it leaves a question unanswered: What happens next year? To come up with the amount to withdraw in 2020, you'll take the value of the account at the end of 2019, and then divide it by a factor that updates your remaining life expectancy. In other words, take the 2019 factor of 36.0 and subtract 1 from it, making the 2020 factor 35.0.

You don't go back to the distribution factor table to come up with the factor for future years. Doing so would give you incorrect information. If you took the factor for a 49-year-old in 2020, you'd get 35.1 rather than 35.0, which could result in a withdrawal that's too small, which could result in substantial penalties for you.

What if you inherit an inherited IRA?

Finally, all of this discussion of stretch IRAs raises a new issue: What happens if the person who inherited the IRA dies before taking out all the assets? In that case, the successor beneficiary of the inherited IRA becomes the new owner of the account.

However, the new heir doesn't get to start the clock over on the stretch IRA option. Instead, the first heir's life expectancy factor is used by the new heir to determine their RMDs. So in the stretch IRA example above, if the first heir died in 2020, the successor beneficiary would still have to use the 2020 factor of 35.0 -- even if that beneficiary were much younger than the first heir.

What are the most common mistakes people make with inherited IRAs?

The most common mistakes people make with IRAs that can affect their inheritance are:

  • The original accountholder fails to name a beneficiary, or doesn't change the beneficiary after key life events like marriage, divorce, death, or the birth of a child.
  • The heir takes out the entire balance of the inherited IRA in a lump sum, unnecessarily incurring a large tax bill all at once.
  • The heir fails to follow the rules for stretch IRA treatment, therefore incurring penalties for not taking RMDs in a timely manner.

For the most part, these mistakes are pretty easy to avoid. But you can't avoid them if you don't know they're there, and that's why so many people end up getting snared unexpectedly by the inheritance rules for IRAs.

How to make the most of your IRA inheritance

If all of this sounds complicated, that's because the rules are designed to cover every possible contingency. Yet at their root, the rules governing inherited IRAs provide retirement savers with a golden opportunity to leave a legacy that can last for decades after they pass away.

If you're fortunate enough to get an IRA inheritance, it's because the original IRA owner planned for the possibility that there'd be money left over in the account at death and wanted you to keep getting the tax benefits of the retirement account. By understanding these rules and using options like stretch IRAs and spousal IRA rollovers, you'll be able to make your inheritance a lasting legacy for yourself and your own loved ones.

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