How to Handle an Inherited IRA

An inherited Individual Retirement Arrangement (IRA) can be a significant financial asset. Understanding how to manage an inherited IRA is important because federal regulations dictate how these funds must be handled. Incorrect management can lead to penalties and unintended tax consequences.

Determining Your Beneficiary Category

Identifying your beneficiary category is the foundational step in managing an inherited IRA, as this classification directly influences your distribution options. The Internal Revenue Service (IRS) outlines distinct categories, each with its own rules governing inherited retirement accounts.

A surviving spouse has the most flexible options. They can roll over the inherited IRA into their own retirement account or treat it as their own, deferring distributions. Alternatively, a spouse can elect to take distributions as an inherited IRA, which allows for more flexibility in certain situations.

Eligible Designated Beneficiaries (EDBs) include individuals who qualify for more favorable distribution periods. This category encompasses the minor child of the original IRA owner, individuals who are disabled or chronically ill, and anyone not more than 10 years younger than the deceased IRA owner. EDB status permits distributions to be stretched over the beneficiary’s life expectancy, providing a longer deferral period.

A Non-Eligible Designated Beneficiary (NEDB) is any individual who does not meet the criteria for a spousal beneficiary or an EDB. This category includes most individual beneficiaries, such as adult children, siblings, or friends of the original IRA owner. These beneficiaries are subject to more accelerated distribution rules.

Non-person beneficiaries, such as trusts, estates, or charities, also have specific rules governing the distribution of inherited IRA assets. The distribution timeline for these entities can vary depending on the type of entity and whether the trust qualifies as a “look-through” trust, which allows its beneficiaries to be treated as individual beneficiaries for distribution purposes.

Understanding Distribution Options and Requirements

Spousal beneficiaries have several choices impacting their financial planning. A surviving spouse can roll over the inherited IRA assets into their own IRA or treat it as their own, making it subject to their own Required Minimum Distribution (RMD) rules based on their age. A spouse can also remain a beneficiary, taking distributions over their life expectancy or under the 10-year rule, depending on circumstances and their age relative to the deceased.

Eligible Designated Beneficiaries (EDBs) are permitted to stretch distributions over their own life expectancy. This allows for a slower withdrawal pace, extending the tax-deferred growth of the inherited assets. For a minor child EDB, the life expectancy rule applies until they reach the age of majority, at which point the 10-year rule begins.

Non-Eligible Designated Beneficiaries (NEDBs) are subject to the 10-year rule. This rule mandates that the entire inherited IRA balance must be distributed by the end of the 10th calendar year following the original IRA owner’s death. While annual distributions are not required within this 10-year period for traditional IRAs where the original owner died before their RMDs began, the entire account must be emptied by the deadline. If the original owner died on or after their RMDs began, annual RMDs must be taken by the NEDB in years 1-9, with the remaining balance distributed by the end of year 10.

For non-person beneficiaries like trusts, estates, or charities, distribution rules depend on the specific entity and its characteristics. If an estate is the beneficiary, IRA assets flow through the estate and are distributed to the estate’s heirs, often subject to the 5-year or 10-year rule depending on the original IRA owner’s RMD status at death. A qualified “look-through” trust, where the trust beneficiaries are identifiable individuals, may allow distributions to be based on the life expectancy of the oldest trust beneficiary, similar to an EDB.

Required Minimum Distributions (RMDs) apply to inherited IRAs for spousal beneficiaries who elect to treat the IRA as their own, and for EDBs taking distributions over their life expectancy. The start date for RMDs for an inherited IRA is the year following the original IRA owner’s death. These distributions must be taken annually to avoid a penalty.

Taxation of Inherited IRA Distributions

Understanding the tax implications is important, as distributions can significantly affect your taxable income. Distributions from an inherited traditional IRA are taxed as ordinary income in the year received. This means the money withdrawn is added to your other income and taxed at your marginal income tax rate. The tax treatment mirrors how the original IRA owner would have been taxed on withdrawals.

In contrast, qualified distributions from an inherited Roth IRA are tax-free and penalty-free. This favorable treatment applies if the Roth IRA has been open for at least five years and the distribution is made after the original owner’s death. If the five-year rule has not been met, earnings might be subject to ordinary income tax.

If the original IRA owner made non-deductible contributions to their traditional IRA, a portion of the distributions may be tax-free. These contributions create a “basis” in the IRA, meaning part of the distribution represents a return of after-tax money. The financial institution or beneficiary may need to track this basis using IRS Form 8606, “Nondeductible IRAs,” to calculate the taxable portion of distributions.

Financial institutions report distributions from inherited IRAs to the IRS. You will receive Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” detailing the amount distributed. This form indicates whether the distribution is taxable and provides information for your income tax return.

In addition to federal income taxes, state income taxes may apply to inherited IRA distributions. State tax laws vary, so understand the specific rules in your state of residence. Some states may tax retirement income differently or have different thresholds for taxation than federal law.

Steps for Managing Your Inherited IRA

After the original IRA owner’s passing, the initial step for a beneficiary is to contact the financial institution where the inherited IRA is held. This could be a bank, brokerage firm, or mutual fund company. They will provide instructions and required forms to begin transferring the account into your name.

You will need to provide documentation to the financial institution. Common requirements include a certified copy of the original IRA owner’s death certificate, a copy of the original IRA owner’s most recent statement, and your personal identification. The institution may also require a copy of the will or trust document to confirm your beneficiary status.

Properly re-titling the account as an “inherited IRA” or “beneficiary IRA” is a key step. The account will be titled in a format such as “John Doe, deceased, FBO (for the benefit of) Jane Smith, Beneficiary.” This titling differentiates it from your personal retirement accounts and ensures it is subject to the correct inherited IRA rules.

Once the account is established in your name, communicate your chosen distribution strategy to the financial institution. This decision should be based on your beneficiary category and financial planning goals, considering the distribution options discussed previously. The institution will process your withdrawal requests according to applicable rules.

The financial institution will provide the necessary paperwork and forms for initiating distributions or transferring assets. These forms will require you to elect your preferred distribution method, such as taking a lump sum, annual withdrawals, or stretching distributions over time if permitted. Carefully completing these documents ensures compliance with IRS regulations.