If you're fortunate enough to have inherited an IRA, congratulations! Most of us are largely on our own when it comes to saving for retirement, so any extra padding for our retirement accounts is welcome. Inherited IRAs come with a lot of rules, though, so you'd better spend some time learning more about them before you take any actions you later regret. Mistakes made with an inherited IRA can cost thousands of dollars.
The rules governing inherited IRAs are more complicated than the ones you face if you simply open and fund an IRA on your own. To appreciate the complexity, remember that there are several different kinds of IRAs, such as the traditional IRA and the Roth IRA. (We have lots of information on the ins and outs of IRAs at our IRA Center -- feel free to take a look.) There are also several different kinds of beneficiaries, such as (a) spouses, (b) children and other non-spouses, and (c) entities, such as trusts, estates, and charities. Each of these groups has its own set of rules governing taxation and withdrawal of funds.
This article will cover the basics, so be sure to learn more about inherited IRAs before taking any actions. It's also a smart step to seek the counsel of a tax professional. That might cost you a little money, but it could save you much more.
If you inherit as a spouse
This is the simplest situation, because you can either "retitle" the IRA, so that it's in your name, or you can rollover the money into a new IRA. The new IRA would also be in your name, of course, and the rollover is a tax-free event. So far so good, eh?
Next, we need to consider what kind of IRA you inherited. If it's a Roth, you can withdraw any or all of the funds tax-free as long as the Roth IRA had existed for at least five years. If it hadn't, once five years pass from its creation, you can withdraw tax-free. If you were the sole beneficiary, you can transfer the assets into a new or existing Roth IRA of your own, and will then follow regular Roth IRA rules, not being able to withdraw funds tax-free until you reach the age of 59 1/2 and the account has existed for at least five years. You will also be able to just leave the assets in the Roth to grow until you die and leave the account to someone else. If you weren't the sole beneficiary, you (and the other beneficiaries) can set up Inherited IRA accounts in your own names. You'll have to either take required minimum distributions, or RMDs, beginning at the end of the year in which your spouse died or when he or she would have turned 70 1/2 -- or you can use the 5-year method, withdrawing all assets within five years after the end of the year in which your spouse died.
A spouse inheriting a traditional IRA has similar options, with slightly different rules. You can withdraw all the money at once, though you'll pay taxes on the sum at your ordinary income rate -- which might be extra high because of the extra income from the inheritance. You can also transfer the assets into a new or existing traditional IRA of your own, subject to RMDs based on your age, or into an Inherited IRA, where withdrawals are based on your spouse's age or are made within five years after the end of the year he or she died.
All that is fairly complicated, and if you don't have a tax pro or expert financial planner guiding you through the process, you may end up doing something suboptimal and facing higher taxes than you had to. Your brokerage may also offer guidance. Tread carefully, because there can be penalties for doing things wrong.
If you inherit as a child or non-spouse
Non-spouses who inherit IRAs cannot just transfer the assets into an IRA in their own name. They can cash it out in a lump sum, but if it was a traditional IRA, they would face income taxes on it. If it's a Roth, they won't -- as long as the IRA had been open for at least five years.
As detailed for the inheriting spouse, you can, alternatively, transfer inherited Roth IRA assets into an Inherited IRA and take RMDs based on your own life expectancy or via the five-year method.
With inherited traditional IRA assets, if the decedent was younger than 70 1/2, you can transfer assets into an Inherited IRA and take RMDs based on your own life expectancy or via the five-year method. If he or she was older than that, you can't use the five-year withdrawal method.
Again, other rules apply, too, so don't act without learning more.
Retitling your Inherited IRA
When you retitle an account, making it an Inherited IRA, you need to do so with care. Here are two examples of how you might do it:
- "John Doe IRA (deceased May 12, 2015) for the benefit of Mary Doe, beneficiary"
- "John Doe IRA (deceased May 12, 2015) F/ B/ O Mary Doe, beneficiary"
The title of the Inherited IRA should include both the name of the deceased party and your name, along with the date of death.
Once the new account is set up, be sure to name one or more beneficiaries for it.
The death of a loved one can be a terribly sad event, but the gift of an inherited IRA can still be a welcome financial aid. Once you have a good handle on the rules, you (perhaps with some professional advice) can make smart decisions about the inheritance so that you maximize its value.