If you inherit a traditional or Roth IRA from a parent, spouse, or other relative, you'll need to know the rules concerning distributions from the account. You'll also need to know how taking a distribution from an IRA could impact your tax bill.
Who did you inherit the IRA from?
The biggest distinction to make regarding distribution rules and requirements is who inherits the IRA -- the deceased's spouse or someone else.
If a spouse inherits an IRA, the rules are quite simple. The surviving spouse can simply treat the inherited IRA as if it were their own. The normal IRA rules regarding future contributions, withdrawals, rollovers, and RMDs apply. In addition, a spouse can choose to take a lump-sum withdrawal.
If a non-spouse inherits an IRA, it's a bit more complicated. Future contributions to an inherited IRA are not allowed, and withdrawals must be taken using one of three methods:
- A lump-sum withdrawal
- Withdrawal of the entire account within the first five calendar years following the original account owner's death
- A series of annual withdrawals based on the life expectancy of the person inheriting the account
Traditional and Roth IRAs are tax-advantaged accounts that allow the investments they hold to grow and compound without capital gains or dividend taxes. And these tax benefits have a limit; you can't simply pass on an IRA through the generations and let the accounts grow tax-free forever.
Generally speaking, the third option on the list -- a series of annual withdrawals -- is the most favorable in terms of avoiding taxes and continuing to take advantage of the IRA's benefits. Taking a lump-sum withdrawal from a traditional IRA can have serious tax consequences, especially if the inherited IRA contains a large sum of money. And the same can be said of withdrawing the entire account within five years.
In contrast, stretching out the withdrawals for as long as possible can not only minimize your tax liability, but it will also allow you to take advantage of the compounding power of tax-deferred investing for the longest possible amount of time.
Will your distributions be taxable?
For the most part, the taxability of IRA withdrawals depends on the type of IRA you're inheriting. If you inherit a traditional IRA, the money you withdraw from the account will typically be included in your taxable income, unless some of the original account contributions were nondeductible (this isn't common).
On the other hand, if you inherit a Roth IRA, your withdrawals will be 100% tax-free, unless the account is less than five years old, in which case the earnings (not contribution) portion of any withdrawal can be taxable.
In any case, distributions from an inherited IRA are not subject to the IRS's 10% early-withdrawal penalty, even if you're under 59-1/2 years old.
Required minimum distributions from an inherited IRA
If you choose to take annual distributions from an inherited IRA, you'll need to calculate the amount you need to take out each year using two things:
- The account's balance as of Dec. 31 of the previous year
- Your life expectancy factor, which you can find in this IRS publication (Table 1, Appendix B)
To determine your required distribution for the first year, use your age at the end of the year following the year of the IRA owner's death. For example, if you inherit an IRA from someone who died in October 2016, you'll use your age as of Dec. 31, 2017 to calculate your first RMD.
As an example, let's say you inherit an IRA with $400,000 as of the end of last year, and your first distribution is based on an age of 45. According to the IRS table linked earlier, your life expectancy factor is 38.8. To calculate your 2017 required distribution, divide the balance by this factor, which gives a required distribution amount of $10,309. Then, in 2018, you'll use the balance as of the end of 2017, along with the life expectancy factor for 46 years old to calculate your next distribution, and so on.
As a final thought, it's extremely important to take your RMD from an inherited IRA every year. The penalty for not doing so is severe: 50% of the amount you failed to take. In our previous example, this would result in a penalty of more than $5,000 if our inherited IRA owner failed to take a distribution in 2017. If you don't want to squander the gift you've been given, it's important to be aware of the inherited IRA distribution requirements and how you calculate them each year.