Understanding Inherited IRAs

Updated: Oct. 6, 2020, 2:37 p.m.

When someone dies with money left in a retirement account, those funds can get passed on to the person’s loved ones through an inherited IRA. The recipients may spend these funds however they choose, but the government decides how long the money may remain in the inherited IRA.

The rules are different for spouses and non-spouses. In either case, understanding all your options is crucial to avoiding penalties and paying the least in taxes overall. Here's what you need to know.

What is an inherited IRA?

An inherited IRA is a tax-advantaged investment account a person or entity opens to house the money they've inherited from a deceased loved one's retirement plan. The person opening the inherited IRA, known as the beneficiary, may be the deceased's spouse, child, other relative, friend, or even an estate or a trust. In the case of multiple beneficiaries, each may open a separate inherited IRA.

Opening an inherited IRA transfers the deceased's assets into your name, so you may spend that money on whatever you like, but you may not make any new contributions to the inherited IRA.

Keep in mind

If you’ve opened an inherited IRA, you will owe income taxes on your withdrawals if your inherited IRA funds are tax-deferred. Roth inherited IRA distributions usually don't affect your taxes, as long as the deceased had a Roth account for at least five years, because they paid taxes on their contributions the year they made them.

Icon hand with dollar sign

Inheriting from a spouse

If you’re a spouse beneficiary, you have the following options when inheriting an IRA:

  1. Roll the inherited funds over into an IRA account in your own name.
  2. Withdraw all of the money in a lump sum.
  3. Withdraw all of the money within five years (if the original retirement account owner died in 2019 or earlier) or within 10 years (if the original owner dies in 2020 or later).
  4. Withdraw funds annually based on your life expectancy.
  5. Disclaim the inherited assets.

Each of these is explained in detail below.

Rolling the inherited funds into an IRA in your own name

Rolling the inherited funds into your own IRA enables you to avoid taking required minimum distributions (RMDs) or paying taxes on your inherited funds until you withdraw the funds in retirement. Delaying these distributions could give your inherited assets time to grow into much more, but once you do this, you may not touch the money again until you're 59 1/2 without paying a penalty, unless the money is in a Roth account or you have a qualifying reason for making the withdrawal, like a large medical expense or first-home purchase.

Lump-sum withdrawal

Withdrawing the money in a single lump sum gives you a lot of money now, but it will also give you a high tax bill this year, unless the money comes from a Roth account.

Five- or 10-year withdrawal method

The five- or 10-year withdrawal method, depending on the year the deceased died, enables you to withdraw the money as often as you'd like in whatever increments you want, as long as it's all withdrawn by the end of the five or 10 years. If you fail to withdraw all funds by then, you'll pay a 50% penalty on whatever remains in the account.

Life expectancy withdrawal method

The life expectancy method determines your annual RMDs by dividing the value of the inherited IRA by the distribution period for your age listed in the IRS Single Life Expectancy Table. You may withdraw more money if you choose, but failure to withdraw at least the RMD results in a 50% penalty on the remainder you should have taken out.

If the original owner was already taking RMDs from their retirement account before their death, you as the beneficiary must take the RMD based on the deceased's age for the year they died, assuming they had not already taken one for that year. You may then begin taking RMDs based on your own life expectancy in the following year.

If the original owner had not yet begun RMDs, you may begin taking RMDs based on your life expectancy as early as Dec. 31 of the year following the year of the owner’s death, or by the end of the year the owner would have turned 72.

Disclaim the inherited assets

You may disclaim, or refuse, some or all of the inherited funds if you don't need them or don't want to deal with the larger tax bill it could bring. If you do this, the funds you would have received will pass to the next beneficiary.

Inheriting from a non-spouse

If you are a non-spouse beneficiary, you have the following options when inheriting an IRA:

  1. Withdraw all the money in a lump sum.
  2. Withdraw all of the money within five years (if the original retirement account owner died in 2019 or earlier) or within 10 years (if the original owner dies in 2020 or later).
  3. Withdraw funds annually based on your life expectancy (select eligible beneficiaries only).
  4. Disclaim the inherited assets.

The options are essentially the same as the options for spouse beneficiaries, except non-spouse beneficiaries may not roll the inherited IRA funds over into an IRA in their own name, and only select non-spouse beneficiaries may use the life expectancy method to calculate their RMDs.

Non-spouse beneficiaries wishing to use the life expectancy method must meet at least one of the following criteria:

  1. They are inheriting the funds from someone who died in 2019 or earlier.
  2. They are chronically ill or disabled.
  3. They are no more than 10 years younger than the deceased account owner.
  4. They are a minor child of the deceased account owner, in which case, they may use the life expectancy method only until they reach 18.

For those who don't qualify for one of these exceptions, the next-best option is often to spread the withdrawals out over 10 years to avoid a large tax bill in any single year.

Inherited IRAs can provide a welcome source of income, but it's important to understand how they're taxed and when you need to get the money out so you don't incur penalties. Review all of the withdrawal options available before deciding which is the best one for you.