When a loved one dies, any leftover IRA funds they had goes to whomever they labeled as beneficiaries. If you're a beneficiary, you have to decide how you're going to use it -- a decision that's a little more complicated this year than it normally is. 

Your loved one's money is yours now, but the government has strict rules about how you can use it and when you must pay taxes on it. Here's what you need to know about your choices.

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What you need to know about withdrawing funds this year

With the COVID-19 pandemic shuttering many businesses at least temporarily, there are a lot of people who could use some extra cash this year, so an inherited IRA can seem like a blessing. It's certainly a better way of covering your expenses than taking on debt, but there are a few things you need to keep in mind.

First, you'll owe taxes on traditional IRA distributions and on Roth IRA earnings if the owner had the account for less than five years. Roth IRA contributions are tax-free because the owner paid taxes on these funds the year they earned them.

Second, the federal government normally mandates annual withdrawals from inherited IRAs unless (1) you're a surviving spouse who rolls the funds over into your own IRA, (2) you take a lump-sum payment, or (3) you use the five-year distribution method. More on those options below. But because many retirement portfolios have plummeted due to the recent market crash, the federal government has waived mandatory distributions for 2020. 

You can still withdraw money if you want to, but you can also leave your money where it is for a whole year. This could potentially increase the value of your inherited IRA if its investments perform well over the next year. Of course, there are no guarantees, but if you don't need the money right now, it might be worth waiting just to see what happens.

Surviving spouses may roll over funds into their own IRA

Surviving spouses who don't have an immediate need for inherited IRA funds should consider doing a spousal transfer. This is where you roll your spouse's IRA funds into your own. The government won't force you to take any money out until you reach 72 -- the age required minimum distributions (RMDs) begin. If you're already 72 or older, you don't have to worry about RMDs this year because they're also waived. Roth IRAs are never subject to RMDs so you can leave that money in your account as long as you'd like, enabling it to grow until you need to use it.

The catch is, if you're not at least 59 1/2, you typically face a 10% early withdrawal penalty for withdrawing funds from your IRA. The government has also temporarily waived this during the COVID-19 pandemic, but it will come back eventually and then you can't use your inherited IRA funds until you are of age. If you're already over 59 1/2, this isn't something you need to worry about.

Rolling the money over into your own IRA is only available to surviving spouses and only if the spouse is the account's sole beneficiary. If you don't meet these two requirements, you must choose one of the other withdrawal options listed below.

Other options for accessing inherited IRA funds

There are a few other options for accessing your inherited IRA funds and these are open to all beneficiaries:

  1. Five-year method (only if the original account owner died before 2020)
  2. 10-year method
  3. Life expectancy method (only if the original account owner died before 2020 or you meet special requirements)

Five- and 10-year methods

The five-year method, available to beneficiaries if the account owner died in 2019 or earlier, lets you withdraw money as often as you want in any amounts, but you must take it all out of the inherited IRA by December 31st of the fifth year following the IRA's original owner's death.

The 10-year method is similar, but it only applies if the IRA's original owner died in 2020 or later. You must use all of the funds by December 31st of the 10th year following the owner's death.

You can choose to take all the money in a lump sum right away if you prefer. This gives you a lot of money now, but you may not get as much overall as you would if you chose to spread it out over several years, especially if your IRA distribution pushes you into a higher tax bracket for the year.

Life expectancy method

Up until this year, the life expectancy method was an option for every beneficiary, but for those who inherit an IRA in 2020 or later, only eligible designated beneficiaries may use this strategy. Eligible designated beneficiaries are surviving spouses, the deceased's minor children, disabled or chronically ill individuals, and anyone not more than 10 years younger than the deceased. Minor children who use the life expectancy method may do so until they turn 18. Then, they have 10 years to withdraw all remaining funds.

The life expectancy method spreads your required distributions out over your life. You divide the account balance by the life expectancy factor listed next to your age in this table. For example, if you were 30 years old and you inherited an IRA worth $100,000, you would divide the $100,000 by the life expectancy factor for a 30-year-old, which is 53.3, and you'd get roughly $1,876. This is the minimum you must take out this year. 

You must start your required distributions no later than December 31st of the year after the IRA owner's death and you must continue taking distributions every year after that until there's no money left in the account. Follow the procedure above every year to figure out how much you must withdraw. You're always free to withdraw more than this amount in a given year if you choose.

Surviving spouses who are older than their deceased spouse may delay distributions until the age the decedent would have turned 72 -- the age when all seniors must begin taking RMDs from their retirement accounts. You can also start right away if you choose.

If an IRA has multiple beneficiaries, each one can set up his or her own inherited IRA and transfer their share of the funds there. Then, each beneficiary can decide how they'd like to withdraw their own funds. If all the money is left in a single inherited IRA and the beneficiaries choose the life expectancy method, the required annual distribution is based on the age of the oldest beneficiary.

There isn't a right or wrong answer when it comes to managing inherited IRAs, but it's generally not wise to start withdrawing funds without exploring all of your options and understanding how your decisions will affect your taxes for the year. Review all of the above strategies before deciding how you plan to take your inherited IRA distributions.