People often die while still owning plenty of assets in their retirement accounts. These tax-advantaged accounts become part of their estate, to be distributed to their heirs.
Unfortunately, the rules governing these inherited retirement accounts are anything but simple. Different rules apply depending on your relationship with the deceased, the age difference between you, and a host of other seemingly irrelevant details.
The news isn’t all bad though. If you inherit an individual retirement account (IRA) balance, its tax advantages carry over to you, and hey, you’re still looking at more money in your nest egg than you had before. Roll up your sleeves and let’s untangle the web of IRS rules.
What Is an Inherited IRA?
Inherited IRAs (also called beneficiary IRAs) are special accounts designed to hold retirement funds inherited from someone else.
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Unless you inherit the account from your spouse, you can’t roll the money from an inherited retirement account directly into your own existing IRA. You have to open a new account specifically for the inherited retirement funds. Bankers imaginatively refer to this new account as an inherited IRA or beneficiary IRA.
You can open an inherited IRA with most brokerage firms, including free brokers and robo-advisors. That part is simple enough and usually only takes five minutes or so. But don’t expect anything else about the process to be simple.
How Inherited IRAs Work
When you inherit any type of IRA, including traditional and Roth IRAs, SEP IRAs, and SIMPLE IRAs, you can open a beneficiary IRA to hold the funds. The same goes for inheriting employer-sponsored retirement plans including 401(k)s, 403(b)s, and Thrift Savings Plans (TSPs).
You open the new inherited IRA with your stock broker of choice and have the executor of the estate transfer the inherited funds to it. After that, you can’t make any new contributions to it — you can only contribute to your own retirement accounts each year.
The tax treatment stays the same from the original account to your new beneficiary account. In other words, after-tax Roth IRA or Roth 401(k) funds go into an inherited Roth IRA, and you transfer before-tax traditional retirement account funds into a traditional inherited IRA.
You may or may not have to take required minimum distributions (RMDs) from your beneficiary IRA. Uncle Sam wants his pound of flesh and he won’t wait forever for it, even with tax-deferred accounts. More on this shortly.
Inherited IRA Rules
Spouses get more flexibility with inherited retirement accounts than most beneficiaries. Which makes sense, given that most married couples merge their finances and share expenses.
One pitfall to watch out for either way: RMDs in the calendar year of the original owner’s death. The government insists that IRA owners take required distributions for the year that the original account owner died.
For example, if the account holder dies in January, they probably haven’t taken their RMDs for that year yet. It’s up to the IRA beneficiaries to determine whether they did or didn’t, and if not, to take an RMD on their behalf. Failure to do so can trigger a penalty of 50% of the amount not withdrawn.
For Spousal Beneficiaries
When you inherit a retirement account from your spouse, you can roll the funds over to your own IRA or Roth IRA. No other inheritors can do this. By rolling the funds over to your own IRA, you don’t have to worry about RMDs until you turn 72 and have to start taking them on your own.
It being your own IRA, you can continue to make new contributions to it. You have 60 days after receiving the funds to roll it into your own IRA. Most spouses choose this route because it’s the most straightforward.
Alternatively, you can leave your spouse’s original account open and name yourself as the owner. But if you take this path, and your spouse had started taking RMDs, you have to continue the same life expectancy plan as your spouse or submit a new distribution schedule. For Roth IRAs, the IRS does hit you with penalties if you withdraw earnings before age 59 ½ and the money hasn’t sat in the account for at least five years.
As a third option, you could leave the account open and remain a beneficiary rather than becoming an account owner. In this case, the RMD schedule remains based on the original owner. You can also withdraw funds penalty-free if your spouse was over 59 ½, even if you’re not.
You have a fourth option as well: open a new inherited IRA and follow the same rules as other types of heirs.
For Non-Spouse Beneficiaries
Non-spouses can’t take control of existing retirement accounts or roll over funds to their own IRAs. They have to open a new beneficiary IRA to hold all money inherited from tax-sheltered retirement accounts, unless they just want to take the money and run. But if you take a lump sum distribution, you have to pay income taxes on it.
Once upon a time, you could withdraw funds from inherited IRAs based on your own RMD schedule. The SECURE Act of 2019 changed all that, creating the “drain-in-10” rule. In most cases, you have to empty inherited IRAs within 10 years. That applies to Roth accounts as well — you can’t let the funds just compound tax-free indefinitely.
As you can guess, that means that early withdrawal penalties don’t apply to inherited IRAs. You can (and often must) withdraw the money before you turn 59 ½.
Exceptions to that rule, so-called “eligible beneficiaries,” include minor children of the deceased, disabled or chronically ill heirs, and heirs within 10 years’ age difference from the deceased. Once minor children reach 18, the drain-in-10 rule kicks in, and they have to empty the account by the time they turn 28.
Unlike with RMDs, the drain-in-10 rule doesn’t force you to stick to a rigid timetable. You can take regular distributions or random one-off withdrawals, or leave the money invested for the entire 10 years and pull it all out at the end.
How Inherited IRAs Are Taxed
Your benefactor already paid income taxes on Roth IRA funds, so you don’t have to pay taxes on them when you take distributions. But traditional retirement funds are a different story.
With traditional IRA or workplace retirement accounts, you pay regular income taxes on withdrawals. Your rich Aunt Susie hasn’t paid income taxes on these funds yet, which means you owe them when you take distributions. If you earned $80,000 in taxable income last year and took $20,000 in distributions, you owe ordinary income taxes on $100,000.
That said, if the estate paid estate taxes on the retirement accounts that you’re inheriting, you can deduct the amount of estate taxes taken out of your windfall.
For example, if you inherit $1 million but the government takes $400,000 of that in estate taxes, you get a tax deduction for that amount that you can carry forward to help offset income taxes on your distributions.
Pros & Cons of Inherited IRAs
I mean, let’s be honest, you’re still richer after inheriting money than you were beforehand. So in that sense, inherited IRAs are all upside. But that doesn’t mean they don’t come with complications and taxes.
What is there to like about inherited IRAs?
- Simplicity for Spouses. Spouses can just roll inherited retirement funds directly into their own IRA or Roth IRA. No complex rules, just extra padding for their nest egg.
- Simplicity for Roth Accounts. In yet another advantage of Roth accounts over traditional retirement accounts, inheriting Roth funds comes with fewer rules and headaches than traditional funds. Heirs don’t have to worry about RMDs or income taxes, they just need to empty the account within 10 years of inheriting funds.
- Open with Any Brokerage. You can open an inherited IRA with just about any investment bank, which lets you keep all your banking in one convenient place.
- Ownership and Flexibility. You own the account and can invest in virtually any asset you like with it.
Aside from the emotional side of losing a loved one, inherited IRAs come with their share of confusion and headaches.
- You Owe Income Taxes. When you inherit traditional retirement accounts, you owe income taxes on each withdrawal. And not at the long-term capital gains rate either — you pay taxes at your regular income tax rate.
- New Account Required. Unless you’re a spouse, you need to go out and open a new account to hold these inherited funds.
- Complexity. Likewise, inheriting traditional retirement accounts also means inheriting headaches surrounding withdrawal rules. You may need to hire an accountant or financial advisor to help you figure out the distribution rules, such as an RMD schedule or when you can access funds if you keep a spouse’s existing account open.
- Drain in 10. In most cases, you must empty the account within 10 years or face stiff penalties from the IRS.
Should You Open an Inherited IRA?
If you inherit a retirement account, you don’t have a choice (unless you’re a spouse).
Well, that’s not true. You can take a lump sum payout immediately rather than opening a beneficiary IRA. But if you do, you owe income taxes on the entire amount this year. That might push you into a higher tax bracket and force you to pay far higher taxes on the money than if you spread it out over 10 years.
Spouses do have a choice in the matter. In most cases, they should simply roll the funds over to their own IRA. But speak with a financial planner before making that decision because you may be better off opening an inherited IRA, especially if you plan to retire early.
Inherited IRA FAQs
Beneficiary IRAs are complicated with a capital C. These represent just a few of the common questions people have about them.
What’s the Difference Between an Inherited IRA & a Roth IRA?
A Roth IRA is your own contributory account, which you open for yourself and can contribute money to each year. You fund it with after-tax dollars, but the money grows and compounds tax-free, and you pay no taxes on withdrawals in retirement.
Inherited IRAs are designed specifically to hold funds that you inherited from someone else. They come with different rules, and they may be either Roth or traditional depending on the deceased’s account type.
What Is the 5-Year Rule for an Inherited IRA?
There are actually several different “five-year rules” when it comes to inherited IRAs.
First, Roth IRAs come with a five-year rule that states that you can’t withdraw earnings within five years of contributing the original money. That carries over to spouses who inherit Roth IRAs: they pay a 10% penalty if they withdraw earnings on funds that haven’t sat in the account for at least five years.
Before the SECURE Act of 2019, there was another five-year rule requiring that you empty inherited IRAs within five years if there wasn’t an existing RMD schedule in place. The SECURE Act replaced that rule with the drain-in-10 rule, applicable to accounts inherited from people who died in 2020 onward.
What Is the 10-Year Rule for an Inherited IRA?
Better known as the drain-in-10 rule, it requires you to empty an inherited IRA within 10 years of opening it. This rule doesn’t apply to spouses or other eligible beneficiaries such as minor children, beneficiaries with disabilities, or heirs less than 10 years younger than the decedent.
Should I Take a Lump-Sum Distribution From an Inherited IRA?
It depends on whether you feel like paying taxes on the entire balance in one year.
For example, if you inherit $200,000 in retirement funds, taking it all at once would drive you into a high income tax bracket, and you’d pay more in taxes. If you spread those distributions over 10 years, it would only add $20,000 per year to your taxable income (ignoring returns), potentially letting you stay in lower tax brackets and paying less in taxes overall.
How Long Do I Have to Transfer an Inherited IRA?
You have 60 days from when you receive the money to transfer it into a newly opened beneficiary IRA.
How Can I Avoid Tax on an Inherited IRA?
If you inherited a Roth IRA, you likely won’t have to pay any income taxes on it. Spouses just need to make sure the funds have sat for at least five years before withdrawing earnings, if they leave the original Roth IRA account open.
It’s harder to avoid taxes when you inherit traditional retirement accounts. As noted above, you can spread the distributions over 10 years. If the estate had to pay estate taxes, you can take a deduction for it as well.
Word to the wise: speak with an accountant or other financial professional if you inherit more than a few grand in retirement funds.
These transactions come with countless rules, variations, and stipulations that make your head hurt. Ain’t nobody got time for that. And one minor misstep can cost you thousands of dollars in unnecessary IRS penalties and taxes.
G. Brian Davis