Inherited IRA: Distribution and Tax Rules

An Inherited Individual Retirement Arrangement (IRA) is an account established when a beneficiary receives IRA assets from a deceased individual. It holds the assets from the decedent’s original IRA but is subject to a specific set of distribution and tax regulations. The rules governing how and when a beneficiary can access the funds are distinct from those that applied to the original owner.

The regulations depend on the beneficiary’s relationship with the deceased. Identifying your beneficiary category is the first step, as this determination dictates the required timelines for withdrawing funds.

Determining Your Beneficiary Status

Regulations from the SECURE Act of 2019 classify beneficiaries into categories that determine the rules for withdrawing funds. These rules apply if the original IRA owner passed away after December 31, 2019. Your beneficiary classification dictates the options and timelines for distributions.

An Eligible Designated Beneficiary (EDB) has the most flexible withdrawal options. The five types of EDBs are:

• The surviving spouse of the original account owner.
• A minor child of the account owner. This status is temporary, ending when the child reaches age 21, and does not apply to other minors like grandchildren.
• A disabled individual, as defined by IRS standards requiring a medically determinable physical or mental impairment that is long-continuing.
• A chronically ill individual, as certified by a health care practitioner as being unable to perform at least two activities of daily living.
• An individual who is not more than 10 years younger than the deceased account owner, such as a sibling.

Individuals who do not meet the EDB criteria are classified as Non-Eligible Designated Beneficiaries. This common category includes adult children, grandchildren, or other relatives more than 10 years younger than the decedent. The distribution rules for this group are more restrictive than those for EDBs.

A Non-Designated Beneficiary applies when the recipient is not a person, such as the deceased’s estate, a charity, or certain trusts. This category has the most rigid rules and requires the fastest distribution of assets.

Required Distribution Timelines

Spousal beneficiaries have the most flexibility. A surviving spouse can perform a spousal rollover, treating the inherited IRA as their own by moving the funds into their personal IRA. This is often advantageous if the surviving spouse is younger than the deceased, as it allows them to delay required minimum distributions (RMDs) until they reach their own RMD age. Alternatively, a spouse can open an Inherited IRA and take distributions based on their life expectancy or follow the 10-year rule.

Other EDBs, like a disabled individual, can take distributions over their own life expectancy, often called a “stretch” IRA. This involves taking smaller annual RMDs based on the IRS Single Life Expectancy Table, preserving tax-deferred growth. For a minor child of the owner, this option is temporary; they must follow the 10-year rule upon reaching age 21.

The 10-year rule is standard for Non-Eligible Designated Beneficiaries, like adult children. It requires the entire account balance to be distributed by December 31st of the 10th year after the owner’s death. However, the requirement for annual distributions during this period depends on when the original owner died.

Owner Died Before RMDs Started

If the original owner died before their Required Beginning Date (RBD) for taking RMDs, the beneficiary is not required to take distributions in years one through nine. You can withdraw funds at any time, as long as the entire balance is distributed by the 10-year deadline.

Owner Died After RMDs Started

If the owner died on or after their RBD, the beneficiary must take annual RMDs for years one through nine based on their own life expectancy. The remaining balance must be fully distributed by the end of the 10th year. Beginning in 2025, the penalty for failing to take these required annual distributions will apply.

Non-Designated Beneficiaries face the most restrictive timelines. If the owner died before their RBD, the account is subject to a 5-year rule, requiring full distribution by the end of the fifth year. If the owner died after their RBD, distributions must be taken based on the deceased owner’s remaining life expectancy.

Process of Claiming and Establishing the Account

To claim the assets, contact the financial institution (custodian) that holds the IRA. You will need to provide certain documents to open the new account:

• A certified copy of the death certificate.
• The deceased’s IRA account number.
• Your government-issued photo identification.
• Your Social Security number.

To maintain the account’s tax-deferred status, you must request a direct trustee-to-trustee transfer. This process moves funds directly from the deceased’s IRA to a newly established Inherited IRA without you taking receipt of the money. Attempting an indirect rollover, where you receive a check, is not permitted for non-spouse beneficiaries and would be treated as a fully taxable distribution.

Properly titling the new account is another requirement. The IRS requires a specific format to identify the account as an inherited asset, such as: “[Name of Deceased Owner], Deceased, for the benefit of [Name of Beneficiary], Beneficiary.”

Failing to use a direct transfer or to title the account correctly can have significant financial consequences. If a beneficiary mistakenly moves funds into a personal IRA (unless they are a spouse performing a spousal rollover), the IRS treats the entire amount as a taxable distribution for that year.

Tax Treatment of Distributions

The tax treatment of distributions depends on whether the original account was a Traditional or Roth IRA. For an Inherited Traditional IRA, all distributions are treated as ordinary income and taxed at your personal federal income tax rate for that year. The 10% early withdrawal penalty does not apply, even if you are under age 59 ½. Because the original funds were pre-tax, the tax liability passes to the beneficiary, which can be significant if a large distribution is taken under the 10-year rule.

Distributions from an Inherited Roth IRA are tax-free if the original account meets the IRS 5-year rule. This rule requires that the deceased owner first contributed to any Roth IRA at least five years before your first distribution. If this condition is met, all withdrawals are free of federal income tax; otherwise, the earnings portion may be taxable.

State tax laws also apply. While most states follow federal rules for IRA distributions, some have their own regulations. A distribution that is tax-free at the federal level could still be subject to state income tax. Beneficiaries should check the rules in their state of residence.