How to Invest Your Inherited IRA Account
Navigate the intricacies of an inherited retirement account. Discover essential steps to manage and strategically invest this financial legacy.
Navigate the intricacies of an inherited retirement account. Discover essential steps to manage and strategically invest this financial legacy.
An inherited Individual Retirement Account (IRA) is a financial asset passed down from a deceased individual to a designated beneficiary. This account has distinct rules that differ significantly from a personal IRA. Understanding these regulations is important for managing inherited funds effectively. This article covers the various types of inherited IRAs, their specific distribution rules, account establishment and investment, and associated tax implications.
Inherited IRAs reflect the original owner’s account type. A Traditional IRA holds pre-tax contributions and earnings, meaning distributions are taxable income to the beneficiary. Roth IRAs are funded with after-tax contributions, and qualified distributions from an inherited Roth IRA are tax-free. Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plans for Employees (SIMPLE) IRAs function much like Traditional IRAs in terms of taxation upon inheritance.
The beneficiary’s relationship to the deceased IRA owner significantly impacts the options for the inherited account. Spousal beneficiaries have the most flexibility, often able to treat the inherited IRA as their own. Non-spousal beneficiaries, such as adult children, siblings, or friends, face different rules and may not roll the funds into their own IRA.
A specific category of non-spousal beneficiaries, “eligible designated beneficiaries,” receives more favorable distribution rules. This group includes the deceased’s surviving spouse, a minor child of the deceased, a chronically ill individual, a disabled individual, or any other individual not more than 10 years younger than the deceased IRA owner. For example, a minor child qualifies as an eligible designated beneficiary until they reach the age of majority, at which point they become subject to the 10-year distribution rule.
Distribution rules for an inherited IRA depend on the beneficiary’s relationship to the deceased and the date of the original owner’s death, particularly in relation to the SECURE Act. For spousal beneficiaries, several options exist. A surviving spouse can elect to treat the inherited IRA as their own, transferring assets into their existing IRA or establishing a new one. This allows the spouse to delay distributions until they reach their own required beginning date for Required Minimum Distributions (RMDs), age 73, and potentially avoid immediate taxation.
Alternatively, a spousal beneficiary can transfer assets to an inherited IRA account titled in the deceased’s name for the spouse’s benefit. Under this option, the spouse is treated as an eligible designated beneficiary, allowing distributions over their life expectancy. A spouse can also take distributions as an eligible designated beneficiary without transferring the account. The choice depends on the spouse’s age, financial situation, and desire to defer taxes.
For most non-spousal beneficiaries of individuals who died on or after January 1, 2020, the “10-year rule” applies. This rule mandates that the entire inherited IRA account must be fully distributed by the end of the calendar year containing the 10th anniversary of the original owner’s death. For instance, if the owner died in 2025, the account must be emptied by December 31, 2035. If the original owner had already started taking RMDs, the beneficiary may need to continue annual RMDs during the 10-year period before fully distributing the account by the deadline.
Eligible designated beneficiaries, as defined by the SECURE Act, are an exception to the 10-year rule. These beneficiaries can stretch distributions over their own life expectancy. They must begin taking RMDs by December 31 of the year following the original owner’s death. This allows for a longer period of tax-deferred growth.
For non-person beneficiaries, such as estates or certain trusts, the rules are more restrictive. If the deceased died before their RMDs began, the 10-year rule applies. If the deceased died after their RMDs began, the account must be distributed over the remaining life expectancy of the deceased, or over the 10-year period if that is shorter.
Establishing an inherited IRA account requires specific documentation. You will need a certified copy of the deceased’s death certificate, which confirms the date of death. You will also need the deceased’s most recent IRA statements, providing account numbers and asset details. Your own identification, such as a driver’s license or state ID, along with your Social Security number, will be necessary to open the new account.
Choosing a financial institution, or custodian, is a step in setting up the inherited IRA. This could be a brokerage firm, a bank, or a mutual fund company. The custodian will provide the necessary inherited IRA application forms, which are available from their website or customer service. These forms require information about the deceased, their original IRA, and your beneficiary status.
When completing the forms, you will specify how the account should be titled, as “[Deceased Owner’s Name] FBO [Your Name] Inherited IRA” (FBO stands for “for the benefit of”). This distinct titling ensures the account is recognized as an inherited IRA, subject to its unique rules. Once the forms are completed and all required documents submitted, they must be sent to the chosen custodian for processing. The custodian will then transfer the assets from the deceased’s original account to your newly established inherited IRA. This transfer should be a direct rollover or trustee-to-trustee transfer to avoid tax implications or penalties from an indirect distribution.
Once the inherited IRA account is established and funded, you can make investment decisions. Available investment options are broad and similar to those within a personal IRA. These include individual stocks, bonds, mutual funds, and exchange-traded funds (ETFs), which offer diversification. For lower-risk options, certificates of deposit (CDs) and money market accounts are available.
Developing an investment strategy for your inherited IRA should consider your individual risk tolerance and the time horizon for distributions. If you are subject to the 10-year rule, your investment horizon is limited, which might lead to a more conservative approach to preserve capital. If you are an eligible designated beneficiary with a longer distribution period based on your life expectancy, you might consider a more growth-oriented strategy. Diversification across different asset classes is advisable to manage risk. Your personal financial goals, such as saving for a down payment or retirement, should also influence your investment choices.
Distributions from an inherited Traditional IRA, SEP IRA, or SIMPLE IRA are subject to federal income tax at your ordinary income tax rate in the year they are received. This is because contributions to these accounts were made on a pre-tax basis, and earnings grew tax-deferred. For example, if you inherit a Traditional IRA and take a $20,000 distribution, that amount will be added to your taxable income for the year.
Conversely, distributions from an inherited Roth IRA are tax-free and penalty-free, provided the original Roth IRA had been established for at least five years before the owner’s death. This is because contributions to a Roth IRA are made with after-tax dollars, and qualified distributions are not taxed. Even if the five-year rule is not met, distributions of the original owner’s contributions are always tax-free.
In addition to income tax, inherited IRAs may be subject to federal estate tax. This tax is levied on the deceased’s estate before assets are distributed to beneficiaries, and it applies if the total value of the estate exceeds a certain threshold, which for 2025 is $13.61 million per individual. The beneficiary receives the inherited IRA after any applicable estate taxes have been paid by the estate itself, so they do not directly pay this tax. Some states may also impose their own estate or inheritance taxes, which could further reduce the net amount received.
Penalties can also arise if required minimum distributions (RMDs) are not taken when applicable. If you are an eligible designated beneficiary or a non-eligible designated beneficiary subject to annual RMDs during the 10-year period, failing to take the correct amount by the deadline can result in a 25% penalty.