Personal Finance

What to Know About Inherited IRAs, Distribution Rules and Tax Implications

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Highlights
In this article

Highlights:

  • An inherited IRA is an IRA that's passed down to a beneficiary after the original account holder's death.
  • The rules for handling your inherited IRA can vary depending on your beneficiary status, your relationship to the deceased and the deceased's age at the time of their death.
  • If you've inherited an IRA, but you're not sure where you stand, consider consulting a financial advisor, tax professional or another expert to help you navigate the process.

Individual retirement accounts (IRAs) are often used to share assets with family, friends and other heirs. However, inheriting an IRA can be complex and come with tax implications. If you're the beneficiary of an IRA, learn how these savings vehicles may impact your inheritance.

What is an inherited IRA?

An IRA, generally speaking, is a tax-advantaged savings account that can help provide a steady stream of income during retirement. An inherited IRA is any type of IRA — including traditional, Roth and SEP IRAs — that's passed down to a beneficiary after the original account holder's death.

Who can inherit an IRA?

There are different categories of IRA beneficiaries. These classifications can influence how you manage your inherited IRA.

  • Eligible designated beneficiaries. This category of heirs includes individuals who are spouses or minor children of the deceased. It also includes individuals less than 10 years younger than the deceased (including siblings), disabled individuals and individuals with a chronic illness.
  • Designated beneficiaries. This group includes all other individuals listed as beneficiaries of the IRA who do not qualify as eligible designated beneficiaries. Adult children of the deceased frequently fall into this category.
  • Trusts and estates. Sometimes, an IRA account holder may choose to assign a trust or their estate as the beneficiary, rather than an individual. In these instances, the trust or estate will determine how the assets are distributed to individual heirs.

What can you do with an inherited IRA?

The rules for handling your inherited IRA vary depending on your beneficiary status and your relationship to the deceased. They also vary depending on how soon you'd like to withdraw funds.

Spouses who inherit an IRA typically have the most options available to them. As a spouse, you might roll the inherited IRA assets into your own retirement accounts. You might also keep the IRA as an inherited account, but declare yourself as the account's new owner. Spouses can generally withdraw funds either as a lump sum or in smaller amounts over the course of several years.

If you're an eligible designated beneficiary or a designated beneficiary, but not a spouse, you won't have the option to roll the IRA assets into your existing retirement accounts. However, you can open a new IRA and transfer your inherited funds into that account. If you choose to keep your inherited funds where they are, you can generally withdraw assets from the existing account as a lump sum or over the course of several years.

If the beneficiary is an estate, the executor will generally treat the inherited IRA according to the terms of the deceased's will.

Most beneficiaries can also refuse to accept an inherited IRA by disclaiming the account.

What are the minimum distribution rules for an inherited IRA?

Regulations surrounding the required minimum distribution (RMD) for an inherited IRA are critical information for any heir. RMDs are the smallest amount that a person is required by law to withdraw from an IRA annually.

RMD rules for an IRA vary depending on the deceased's age at the time of their death. If you've inherited a traditional IRA and the deceased had not taken their yearly RMD at the time of death, you must withdraw the minimum amount. If not, you risk a tax penalty equal to 50% of the RMD. Going forward, you must also follow standard RMD guidelines, which kick in at age 73.

Roth IRAs are not typically subject to RMD rules. However, inherited Roth IRAs are an exception: if you're the beneficiary of a Roth IRA, you will still have to meet RMD requirements each year.

What is the 10-year rule for inherited IRAs?

Under the 10-year rule, the funds inside IRAs inherited on or after January 1, 2020 must be distributed or completely withdrawn 10 years after the original account holder's death. Because of this rule, beneficiaries of an IRA may be required to make early withdrawals in order to empty their inherited accounts. In these cases, beneficiaries are typically exempt from the typical 10% early withdrawal tax penalty.

If you fail to follow the 10-year rule, you will face a stiff tax penalty. However, some eligible designated beneficiaries, such as spouses, are exempt from the 10-year rule.

How can you avoid taxes on inherited IRAs?

Withdrawals from inherited IRAs may be taxable depending on the type of account. While you can never fully avoid taxes on your inherited IRA, some withdrawal scenarios are more costly than others. For instance, taking a lump-sum distribution tends to result in a large tax bill. Depending on the distribution's size, it can even move you into a higher tax bracket, which means all of your income for that year will be taxed at a higher rate.

To spread out the taxes you pay over a longer time frame, it's typically wise to take your distributions in smaller amounts over the 10-year period. If you're a spouse, you can also reduce your tax burden by moving the funds into your own retirement account. Just make sure you're following IRS regulations closely to avoid additional tax penalties and an inflated tax bill.

IRS laws governing inherited IRAs can be tricky. If you've inherited an IRA but you're not sure where you stand, consider consulting a financial advisor, tax professional or another expert to help you navigate the process.

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