Inherited IRAs

Whether you inherit an IRA from a spouse or parent, or at some time in the future your IRA will be inherited by your spouse or children, there are some important things to consider.  Distributions from IRAs, including inherited IRAs, are considered taxable income.  Therefore it’s usually a good idea to leave the money in the IRA for as long as possible so that the earnings grow tax deferred for as long as possible.

  • Spouse:
    • Money in an IRA that is inherited by a spouse can either be:
      • Left in the original IRA account to continue to grow until the surviving spouse reaches the age of 70 ½; or
      • Rolled into a new account.
    • If there is a significant age difference between the deceased and surviving spouse, the surviving spouse should retitle the inherited IRA account when he or she reaches the age of 59 ½. This allows the surviving spouse to defer any withdrawals until the surviving spouse reaches the age of 70 ½. Otherwise withdrawals would need to begin when the deceased spouse would have reached 70 ½, not the surviving spouse.
    • If the surviving spouse takes a distribution before he or she reaches the age of 59 ½, the IRS imposes a 10% early withdrawal penalty.
  • Non-spouse
    • Non-spouse beneficiaries cannot roll over the funds into their existing IRA account but must set up and retitle the IRA as an inherited account.
    • Non-spouse beneficiaries can opt to leave the funds in the account and take the distributions over their own life expectancy, leaving the funds to continue to grow tax deferred; or liquidate the IRA account within five years of the original owner’s death. However, in either case, the first distribution must be taken by December 31 of the year following the original owner’s death.
  • Roth IRA
    • If a spouse inherits a Roth IRA, no distributions are required unless the surviving spouse treats the inherited IRA as his or her own. Earnings in a Roth IRA continue to accrue tax free unless the inherited Roth IRA was set up less than five years before the original owner’s death. If the Roth IRA was set up less than five years preceding the original owner’s death, taxes may be imposed on the withdrawals.
    • If a spouse treats an inherited Roth IRA as his or her own, any distributions taken before age 59 ½ could be subject to a 10% early withdrawal penalty. For this reason it’s usually a good idea to leave the money in the account for as long as possible without taking any distributions.
    • Non-spouse Roth IRA beneficiaries must take any required minimum distributions (RMDs), but these distributions are tax free.

Some other things you should be mindful of:

  • Did the original owner take any RMD for the year that he or she died? If not, and the beneficiaries do not take the RMD within the required time frame, they could be liable for a 50% penalty based on the amount that should have been withdrawn. December 31 is the deadline for taking RMDs. This time frame is particularly sensitive if the original owner dies late in the calendar year.
  • The 50% penalty for not taking an RMD may be avoided if the account is depleted within five years.
  • Remember however that in some instances, the penalty for not taking an RMD may be LESS than what would have been earned on the account.
  • Although distributions from inherited IRAs are taxable, if the estate is large enough, the beneficiaries may be eligible for an income tax deduction for any federal estate taxes paid on the IRA account.
  • As an IRA owner, be sure that the designated beneficiary form is properly and completely filled out and that the form is on record with the custodian of the plan.
  • You may want to designate primary and alternate beneficiaries. Primary beneficiaries retain the right to disclaim the account and then pass it on to an alternate beneficiary, thus prolonging the tax deferred growth of the funds for a longer period of time.
  • If you opt to list a trust as a primary beneficiary, be sure that the trust provisions are properly drafted and that the qualified beneficiaries are clearly designated.
  • If the estate is the beneficiary, Roth IRA funds must be withdrawn within five years. For a traditional IRA, the distribution is based on the age of the original owner, unless the decedent was already 70 ½ years old.
  • For multiple beneficiaries, the IRA should be split into as many separate new IRAs as necessary; otherwise, the age of the oldest beneficiary will be used to determine RMDs, regardless of the age of the youngest beneficiary.

Consult with a professional tax advisor to ensure that you are getting the maximum tax deferment benefit from an inherited IRA and avoiding any unnecessary penalties.