IRAs were created to help people save enough to meet their financial needs in retirement. But often, people die before they've completely used up their IRA money. It's important to know what happens after an IRA owner passes away so that surviving family members handle the IRA correctly and avoid some pitfalls for the unwary.
Who gets the IRA?
The first thing you have to do is to determine who inherits the IRA assets. To answer that question, the only thing you typically need is the beneficiary designation form that the IRA owner completed. That document controls who gets the IRA even if it is in conflict with a will or other estate planning documents.
Only if the IRA beneficiary form was never filed, doesn't list a valid beneficiary, or lists the estate as the beneficiary do you then have to look for a deceased person's estate planning documents. In those limited cases, the will controls who receives IRA funds.
What happens to the IRA?
Beneficiaries have a couple of choices when they inherit an IRA. If the decedent hadn't yet turned 70 1/2, then the beneficiaries can take out the entire balance of the inherited IRA within five years. If the IRA is a traditional IRA, then they'll pay income taxes on the amount they withdraw in the tax year during which they withdraw the funds.
Alternatively, IRA heirs can elect to start taking regular distributions on an annual basis, using a life expectancy calculation that's similar to what IRA owners have to use once they turn 70 1/2 and have to start making required minimum distributions from the retirement account. This "stretch IRA" option gives you the greatest potential tax savings, especially if the heir is relatively young.
A special rule for spouse beneficiaries
In addition to the options above, a surviving spouse who inherits an IRA has a third option. Rather than treating the deceased spouse's IRA as a separate account, the surviving spouse can roll the assets over into an IRA in the surviving spouse's own name. From there on out, the inherited assets are treated in exactly the same way as any other IRA assets that the surviving spouse might already have owned.
There are advantages and disadvantages to the spousal rollover option. On one hand, spousal rollovers avoid having to take distributions within a short period of time following the deceased spouse's death. Moreover, most retirees look first to leave assets to a spouse, and so the option is commonly used. However, spousal rollovers can have negative effects as well. For instance, if the deceased spouse was over age 59 1/2 but the surviving spouse is under 59 1/2, then rolling the deceased spouse's IRA into the surviving spouse's retirement account subjects the inherited money to the 10% early distribution penalty. By contrast, distributions from an inherited IRA left in the decedent's name are not subject ot the 10% penalty.
How to deal with inherited IRA logistics
Finally, it's extremely important to make sure that the financial institution that's handling the IRA makes changes to the registration of the account to reflect whatever decision you make. For those who can't or choose not to use the spousal rollover option, then the ownership of the IRA will look something like "Richard Smith, as beneficiary of the Jane Smith IRA." Only the spousal rollover option will eliminate the deceased person's name from the account.
Dealing with financial matters after the death of a loved one can be difficult, and IRAs have added complications. However, by understanding what happens with an inherited IRA, you can be more comfortable that you'll do everything you can to honor the memory of the loved one who passed away.