You’ve inherited an individual retirement account, or IRA. Now what?
Unfortunately, you cannot leave the money in the original IRA opened by the deceased person. There are several ways you can receive the funds after inheriting either a traditional or Roth IRA, but your options will be narrowed by a few factors. Failure to handle an inherited IRA properly can lead to a significant penalty from the IRS.
“Understand what type of beneficiary you are under the new SECURE Act, what options are available to you, and how they fit into your tax and investment profile,” says Mark Struthers, founder of Sona Wealth Advisors based in St. Louis Park, Minn.
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Here’s what you need to know about inheriting an IRA.
Get a Grasp on What You Have Inherited
The first step after being left an IRA is figuring out key details about the account, including whether it is a traditional IRA or a Roth IRA. Unlike Roth IRAs, traditional IRAs require the owner to take minimum withdrawals when they turn 72. Because of that, if the original account owner was older than 72 when they passed away, make sure the required minimum distribution has been met for the year. Otherwise, you face a potentially significant penalty from the IRS.
Also, identify when the account was opened––which could exempt you from taxes later on if you inherited a Roth IRA––and determine if you are the sole beneficiary or if the IRA is shared with others.
Then, take stock of your own financial position, recommends Jeffrey McDermott, founder of Create Wealth Financial Planning based in Saint Johns, Fla. Do you need to withdraw money now, or can you keep it in there to grow more in the future?
Natalie Choate, author of Life and Death Planning for Retirement Benefits, urges beneficiaries to also ask themselves if they even want to inherit the money.
“For most people, the answer is, ‘Yes, next question please,’” says Choate, a retired estate planning attorney in Wellesley, Mass. “But sometimes an inheritor wants to ‘disclaim,’ or refuse, an inheritance and let it pass to the next beneficiary.”
For example, if an IRA is left to two siblings–––one of whom is wealthy and the other who is not––the wealthy one might want to disclaim the inheritance to pass the entire account to the sibling.
Spousal Heirs Can Transfer the Funds to a New IRA
Through what’s called a spousal transfer, all spousal heirs have the option to transfer the assets from the original owner’s account to their own existing or a new IRA. You can complete a spousal transfer even if the deceased person was over the age of 72 and taking RMDs from a traditional IRA; with your existing or new account, you can delay RMDs until you turn 72. You can also complete this type of transfer with a Roth; since these accounts don’t require RMDs, you won’t need to worry about withdrawals.
This option is good for beneficiaries who are younger than their deceased spouses and don’t need the income yet, says Michael Kelly, president and financial planner at Switchback Financial in Madison, Conn. Transferring the funds to your own traditional IRA allows you to delay taking RMDs.
However, if you would like to withdraw the funds from the new IRA before you reach the age of 59 ½, you’ll be subject to the 10% early-withdrawal penalty.
Spousal Heirs Could Do a Stretch IRA
Spousal heirs who inherit either a traditional or a Roth IRA could transfer the assets into an inherited IRA. Keep in mind that this option is different from the spousal transfer.
The original account owner’s financial institution will require you to open the inherited IRA with them. But you can also move the funds to a new bank. Choate recommends that you first open an inherited IRA at the original owner’s institution and then open an inherited IRA at the institution you want to move the account to. Then request a direct IRA-to-IRA transfer from the previous bank to the one you prefer.
When titling the account, follow the format: “[Decedent’s Full Name], for benefit of [Beneficiary’s Full Name]” or “[Beneficiary’s Full Name], as beneficiary of [Decedent’s Full Name].”
Once your inherited IRA is set up, you can then withdraw the funds in two ways. The first is the life expectancy method where you take annual distributions based on your own life expectancy, not the original owner’s. This is type of IRA is also called a stretch IRA.
Overall, this option best suits beneficiaries older than the deceased person, since it delays RMDs from the inherited funds until the deceased spouse would have turned age 72, suggests Kelly. Still, if you want to take out a distribution before you reach the age 59 ½, you will not incur the 10% penalty like in the spousal transfer. Your assets can continue to grow tax-deferred.
The second option is the 10-year method, where you have to withdraw all funds within a decade. Most spousal heirs tend not to choose this option, according to McDermott.
Non-Spousal Heirs Have More Limited Choices
The SECURE Act of 2019 eliminated a stretch IRA for non-spousal heirs who inherit the account on or after Jan. 1, 2020. The funds from the inherited IRA – either a Roth or a traditional IRA – must be distributed within 10 years of the original owner passing away. This applies regardless of whether the deceased person died before or after the year in which they reach age 72.
There are exceptions to this. For instance, if the heir is a minor, disabled or not more than a decade younger than the original account owner then they can withdraw the funds using the stretch IRA method.
If you are required to take out the funds within 10 years, you do not need to withdraw a certain amount of money each year from an inherited IRA. Instead, you can leave the funds to grow in the account tax deferred that entire time and then withdraw the funds at the end.
But be wary of withdrawing too much in one year from a traditional IRA. Doing so could move you into a higher tax bracket, warns Mark Teitelbaum, vice president of advanced markets at Equitable, a financial services company in New York.
You Could Take the Money in a Lump Sum
All beneficiaries have the option to take the funds in one large distribution, either from a traditional or Roth IRA. However, McDermott generally discourages clients with traditional IRAs from choosing this option, as they’ll have to pay income taxes on the distribution all at once and may move to a higher tax bracket.
Plan for Taxes on Your Distributions
Those who inherit a Roth IRA should not have to pay taxes on distributions if the original account was opened at least five years ago or a conversion from a traditional IRA to a Roth happened at least five years ago. See when the original account was opened to determine whether a portion of the distribution will be taxable.
Withdrawals from other types of IRAs––including a traditional IRA, SEP IRA, and SIMPLE IRA––are fully taxable.
“Any time you take a distribution from this account, the distribution will be income to you that must be reported on your income tax return, and, of course, taxed,” says Choate.
If Needed, Turn to Help
Consult with a financial planner, accountant, or estate planning lawyer who is familiar with IRA rules, recommends Choate.
A simple process like this shouldn’t but can go wrong if you don’t follow the rules. The IRA could get transferred into the wrong account, such as a non-IRA brokerage account. Unpaid RMDs for that year may not have been realized. Especially with large inherited IRAs, your planner should help you map out the best distribution strategy.
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