understanding gift tax

Inherited IRA – What to do Now

Receiving an inheritance is never good under any circumstances.

Unfortunately, you just received an inherited IRA and are not sure what the next step should be.

Inherited IRAs come at a tough time. We’re here to help you avoid adding additional pressure and stress to the situation by making a wrong move with the inherited IRA. Making the wrong steps at this point can cost you in taxes and penalties.

When you inherit an IRA, the next step depends on if required minimum distributions have started and if you are a spouse of the decedent. It will take a little planning on your part to decide what to do next, but it will be much easier when you have all the information at hand. Let’s talk about the differences between a Traditional IRA and a Roth IRA and what it means when you inherit them.

Traditional versus Roth IRA

Individual retirement accounts come in two main categories. Pre-tax and post-tax. A Pre-tax retirement account means the money that goes into the IRA has not been taxed yet. This is a Traditional IRA; you contribute money to the account and can deduct that money on your current year’s tax return. Later, when you do decide to take money out for retirement, you will pay tax on that money at that time.

A Roth IRA, on the other hand, is a post-tax retirement account. This is because you contribute after tax money to the account. The good part here is when you take money out in retirement, it is tax free.

Let’s discuss which type of retirement account is better later. The idea here is to understand which type of account you will be inheriting, and how it affects your options.

Have Required Minimum Distributions Started

The first question you must answer about your inherited IRA is, did the decedent start required minimum distributions in their IRAs?

Traditional IRAs are great for kicking tax can down the road, but eventually, the tax man (IRS) wants their money from that retirement account. If the decedent is over the age of 70 ½, they are required to take minimum distributions. These distributions will be taxable and will ensure that the IRS starts to collect their money.

Anytime a required minimum distribution is missed or is not taken in full, the IRS will levy a 50% penalty on the amount not removed from the account.

If you have inherited a Roth IRA, required minimum distributions will not have started for the decedent. The IRS has already collected their tax on the money in the account, and the money won’t be taxed again when it is withdrawn, so the IRS is not interested in requiring minimum distributions for these accounts.

Are You a Spousal Beneficiary

Were you married to the person that passed on the IRA to you? If you were, you are a spousal beneficiary and have a few more options available to you.

If you are a spousal beneficiary, and the decedent started required minimum distributions, you have three options:

  1. You can roll the IRA into your own. This has the same effect as having your own IRA. It doesn’t matter if this is your first traditional IRA, or you already an established IRA to which you are adding. Once this money becomes your IRA, you must follow all the traditional rules. First, you can only remove this money penalty-free, after the age of 59 ½. Next, you must start your own required minimum distributions after the age of 70 ½. Finally, you will have to designate your own IRA beneficiary.
  2. Your second option is to have the assets transferred into an inherited IRA in your name. Since required minimum distributions have already started, you must continue taking the required minimum distributions. It does not matter if you are over the age of 70 ½. The distributions will be taken based on your life, using the single life expectancy table from the IRS. The required minimum distributions will be taxed at your ordinary tax rate. If you take this route, you will not incur any 10% penalties for early withdrawal. There is another downside to taking this route. If you have an inherited IRA, you cannot name a primary beneficiary. You must name a successor beneficiary. The difference here is that if the successor beneficiary inherits the IRA, they will have to continue taking required minimum distributions based on your life. This typically causes the required minimum distributions to be extremely high and hits the successor with a large tax bill.
  3. Your last option is to take a lump sum distribution. Just as it sounds, this is taking all the money at once. You avoid the 10% penalty if you are under 59 ½, but you have to pay tax on that large distribution.

Out of the three options, typically you will want to combine Option 1: Roll the IRA into your own and Option 2: Transfer the assets to an inherited IRA. This is especially true if you are under the age of 59 ½. We recommend a combination because the IRA can be split into each option. If you will need a little money after the passing, keep that money in the inherited IRA. Remember, you will be able to take that money out without penalty. Move the rest of the money into your IRA. This will stop the required minimum distributions and allow you to easily manage the IRA as your own.

What happens if your spouse hadn’t started taking their required minimum distributions? In this case, you are given the same options as before, plus one additional option.

4. Open an inherited IRA and close the account within 5 years. This additional option allows the account to continue to grow for 5 years and then you can close the account and withdraw all the money. The only downside here is that you will have to pay tax on the amount of the withdrawal. There will be no 10% penalty for early withdrawal.

The options for an inherited Roth IRA are not that different for a spouse. Although, there are some interesting nuances that occur when you inherit a Roth IRA.

First, you still have the option to roll the Roth IRA in your own IRA. With Roth IRA’s, this is probably one of the best options.

Second, you can open an inherited IRA. The issue here is that you will need to distribute the money from the account. You must start required minimum distributions on the later of the date when the decedent would have turned 70 ½ or by December 31st of the year following the year of death.

If you choose not to start required minimum distributions, or you forget, you will have to close the account within 5 years.

Normally, the IRS does not require minimum distributions from a Roth IRA, but they don’t want these accounts to sit around forever moving from one person to the next.

Your last option is to just take all the money from the account. This will allow you to take the money out tax and penalty free.

You Are a Non-Spousal Beneficiary

When you are a non-spouse beneficiary you have more limited options. A non-spouse can be everything from a friend, family member, an estate or another non-human (ex: charities, pets, etc.).

If you are a non-spouse beneficiary, and the decedent started required minimum distributions, you have two choices:

  1. Continue taking required minimum distributions. Since required minimum distributions have already started, you must continue taking the required minimum distributions. It does not matter if you are over the age of 70 ½. The distributions will be taken based on your life, using the single life expectancy table from the IRS. The required minimum distributions will be taxed at your ordinary tax rate. If you take this route, you will not incur any 10% penalties or early withdrawal.
  2. A lump-sum distribution. Your second option is to take a lump-sum distribution. Just as it sounds, this is withdrawing all the money at once. You will avoid the 10% penalty if you are under 59 ½ but you will have to pay tax on that large distribution.

Being a non-spousal beneficiary does not leave you with a lot of options. If the decedent was over the age of 70 ½, and they were required to take the required minimum distributions, you have the same options as if they were under 70 ½, plus one additional option:

3. Move the IRA to an inherited IRA and close the account in 5 years. This additional option is to move the IRA to an inherited IRA and close the account out within 5 years. You do not have to take the money out in one lump sum; it can be taken out over 5 years. At the end of the 5 years, the account needs to be closed. You will have to pay tax on the distribution, but no early withdrawal penalty will be assessed.

If you are dealing with a Roth IRA, you will have all the same options as a Traditional IRA for a non-spouse beneficiary.

As you can tell, dealing with an inherited IRA can get quite complicated. It can dial up an already stressful situation.

There are several nuances of which you need to be aware. First, remember distributions from a traditional IRA do count as income. You know this because you will pay income taxes on them. However, that also means these distributions can knock you into a higher tax bracket, an additional factor you should be aware of and consider.

Second, you don’t need to be in a hurry to decide if you want to keep the IRA as an inherited IRA or if you should roll it into your own IRA. The IRS gives you until December 31st after the year of death to decide if you want to keep the inherited IRA or roll it into your own.

Third, if the decedent died without taking a required minimum distribution, assuming they are over 70 ½, you first need to remove the required minimum distribution. Forgetting or waiting too long can cause you to be subject to penalty.

Conclusion

Inherited IRAs can be extremely complicated, especially in a tough situation. If you are not sure what to do at the proper moment, it can severely limit your options or subject you to penalties.

When you inherit an IRA, you must first decide if the decedent needed to start their required minimum distributions. If they did, you will have to make sure their last distribution was taken and if not, you will be required to get that money out quickly.

Being a spouse always gives you the option to roll the money into your own IRA account. It doesn’t matter if you did not have an IRA account before, you can start one with the inherited money. Rolling the money over is usually the best option, but it does limit your access to the money. Once the money is in your account, it will act like your money. It no longer carries over any inherited benefits.

The positive is that the only real time limit is taking care of the required minimum distribution. You can wait to make the decision on rolling the money over or keeping it as an inherited IRA.