Inherited an IRA? Now What Are Your Options?

Inheriting an Individual Retirement Arrangement (IRA) often follows the loss of a loved one. Understanding the options for managing this inherited asset can provide clarity. This article guides you through the initial considerations and choices when you become an IRA beneficiary, clarifying the steps necessary to handle the account.

Identifying Your Beneficiary Type and Its Rules

The initial step after inheriting an IRA involves determining your specific beneficiary classification, as defined by IRS regulations. Your classification dictates the rules for receiving distributions, and options for managing funds vary based on this designation.

A key distinction exists between a spouse and non-spouse beneficiary. A spouse generally has the most flexibility, often treating the IRA as their own. Non-spouse beneficiaries face different rules depending on their relationship to the deceased.

Non-spouse beneficiaries are further categorized as eligible or non-eligible designated beneficiaries. Eligible designated beneficiaries include individuals who are disabled, chronically ill, or not more than 10 years younger than the deceased IRA owner. Minor children of the deceased IRA owner also fall into this category until they reach the age of majority.

Non-eligible designated beneficiaries typically include siblings, nieces, nephews, or friends. These individuals generally have fewer options for stretching out distributions. The original IRA owner’s age at death also plays a role, specifically whether they had already begun taking required minimum distributions (RMDs) before their passing. This can impact the timing of required distributions for the beneficiary.

Non-person beneficiaries, such as trusts or estates, face complex rules. If an IRA is inherited by an estate, distribution rules generally follow those that would have applied to the deceased IRA owner. For trusts, rules vary based on whether the trust qualifies as a “see-through” trust, which allows underlying beneficiaries to be treated as designated beneficiaries for RMD purposes.

Your Distribution Choices

After identifying your beneficiary type, explore the options for receiving distributions from the inherited IRA. Each choice carries different implications for withdrawal timing and tax treatment, with flexibility depending on your specific beneficiary classification.

Spouse beneficiaries have several flexible choices. A spouse can roll over the inherited IRA into their own IRA, treating it as their own retirement account. This allows for continued tax-deferred growth and postpones required minimum distributions until the spouse reaches their own RMD age. Alternatively, a spouse can elect to treat the inherited IRA as their own IRA, combining it with existing retirement funds and managing it under their own RMD schedule.

A spouse may also choose to remain a beneficiary of the inherited IRA, taking distributions based on their own life expectancy or the deceased’s life expectancy if the deceased had already begun RMDs. This option maintains the inherited account as a separate entity. The decision between these options depends on the spouse’s age, financial needs, and long-term retirement planning goals.

Non-spouse beneficiaries generally have different options, with the “10-year rule” being common for many designated beneficiaries. Under this rule, the entire inherited IRA balance must be distributed by the end of the tenth calendar year following the original IRA owner’s death. The entire account must be emptied by the deadline, potentially leading to a large taxable event in the tenth year.

Certain eligible designated beneficiaries (e.g., minor children of the deceased, chronically ill, or disabled individuals) may qualify for a “stretch IRA” option. This allows distributions over their own life expectancy, offering longer tax deferral compared to the 10-year rule. A lump sum distribution option is available to all beneficiary types, allowing the entire account balance to be withdrawn immediately, though this results in the full amount being taxed in the year of withdrawal.

Understanding Required Withdrawals

Inherited IRAs require understanding mandatory withdrawals, known as required minimum distributions (RMDs). These annual withdrawals must begin by specific deadlines to avoid penalties. Timing and calculation depend on your beneficiary type and whether the original IRA owner had already started their own RMDs.

For most non-spouse designated beneficiaries subject to the 10-year rule, the entire inherited IRA balance must be distributed by December 31st of the tenth year following the owner’s death. If the original IRA owner died on or after their RMD required beginning date, annual RMDs based on the beneficiary’s life expectancy may be required during the 10-year period, with the remaining balance distributed by the end of the tenth year.

Spouse beneficiaries who treat the inherited IRA as their own or roll it into their own IRA follow their own RMD schedule, starting when they reach their RMD age. If a spouse remains a beneficiary, RMDs generally begin by December 31st of the year following the owner’s death, based on their life expectancy. For eligible designated beneficiaries who stretch distributions, RMDs typically begin by December 31st of the year following the owner’s death, based on their life expectancy.

Failing to take a timely RMD can lead to penalties. The IRS imposes a 25% excise tax on the undistributed amount. This penalty can be reduced to 10% if corrected promptly and a reasonable cause is demonstrated. Understanding these rules ensures compliance and avoids unnecessary tax burdens.

Taxation and Account Administration

Distributions from an inherited IRA carry important tax implications that beneficiaries must consider. Generally, withdrawals from a traditional inherited IRA are taxed as ordinary income in the year they are received. This means the distribution amount is added to your other taxable income for the year, potentially increasing your overall tax liability.

In contrast, qualified distributions from an inherited Roth IRA are typically received tax-free. This is because contributions to Roth IRAs are made with after-tax money, and earnings grow tax-free, provided certain conditions are met, such as the account being open for at least five years and the distribution being made after the original owner’s death. While income tax is the primary concern for most inherited IRAs, larger estates, including the value of an IRA, might be subject to federal estate taxes. This is separate from the income tax on distributions and applies only to estates exceeding a high exemption threshold. All distributions from an IRA, whether traditional or Roth, are reported to you and the IRS on Form 1099-R.

Administratively, claiming an inherited IRA begins with contacting the financial institution (custodian) that held the deceased owner’s IRA. You will need to provide necessary documentation to prove your identity and the death of the IRA owner. This typically includes a certified copy of the death certificate, your government-issued identification, and any beneficiary designation forms on file with the custodian.

The custodian will then guide you through re-titling the account in your name as the beneficiary. The account will typically be re-titled in a format such as “John Doe, Beneficiary of Jane Doe’s IRA.” Once the account is properly re-titled, you will select your chosen distribution method from the options available to your beneficiary type. Seeking guidance from a qualified financial advisor or tax professional is advisable to navigate these complexities and make informed decisions.