What Can I Do With an Inherited IRA?

An inherited Individual Retirement Arrangement (IRA) is an account established when an individual receives retirement funds after the original owner’s death. This differs from a personal IRA, which an individual funds and manages throughout their working life. While both account types offer tax advantages, the rules governing inherited IRAs are distinct and often more complex. The specific regulations for an inherited IRA depend on the beneficiary’s relationship to the deceased owner.

Understanding Inherited IRAs

An inherited IRA is specifically set up by a designated beneficiary to receive assets from a deceased person’s retirement account. These accounts cannot receive new contributions. The tax treatment of an inherited IRA mirrors that of the original account, whether it was a Traditional or Roth IRA.

With a Traditional Inherited IRA, distributions are taxable as ordinary income, reflecting the pre-tax nature of the original owner’s contributions and earnings. Conversely, a Roth Inherited IRA allows for qualified, tax-free distributions, assuming the original Roth IRA met specific holding period requirements. When an IRA is inherited, the account is retitled to reflect the deceased owner and the beneficiary, for example, “John Doe (deceased) FBO Jane Smith (beneficiary).” This retitling signifies the change in ownership, which cannot be commingled with the beneficiary’s personal retirement accounts.

The Internal Revenue Service (IRS) distinguishes between “designated beneficiaries” and “non-designated beneficiaries,” which impacts distribution options. A designated beneficiary is an identifiable individual, such as a spouse, child, or other person. Non-designated beneficiaries include entities like charities or the deceased’s estate. Individual beneficiaries have more flexibility.

Options for Different Beneficiary Types

The choices for managing an inherited IRA depend on the beneficiary’s relationship to the deceased account owner. Each category has distinct options and implications.

Spousal beneficiaries have the most flexibility. A surviving spouse can choose to treat the inherited IRA as their own, rolling over the funds into their existing IRA or a new one. This option allows for continued tax deferral, with required minimum distributions (RMDs) not beginning until the spouse reaches their own RMD age, currently 73. Alternatively, a spouse can remain as a beneficiary of an inherited IRA, which provides benefits such as taking distributions before age 59½ without the 10% early withdrawal penalty.

Non-spousal beneficiaries, including children, other relatives, or friends, cannot treat the IRA as their own. They must establish a new inherited IRA account.

The primary distinction among non-spousal beneficiaries is between “eligible designated beneficiaries” (EDBs) and “non-eligible designated beneficiaries” (NEDBs). EDBs include minor children of the deceased (until they reach the age of majority, usually 21), individuals who are disabled or chronically ill, and individuals not more than 10 years younger than the deceased. These EDBs may be able to stretch distributions over their life expectancy.

For most non-eligible designated beneficiaries, the primary option is to withdraw the entire inherited IRA balance within 10 years following the original owner’s death. This “10-year rule” means the account must be fully depleted by December 31st of the year containing the 10th anniversary of the owner’s death. While distributions are not necessarily required every year within this period, the entire balance must be distributed by the deadline. This rule applies to most non-spouse beneficiaries inheriting from owners who died in 2020 or later.

When a trust is named as the beneficiary of an IRA, the rules become more complex, depending on the trust’s type. A “conduit trust” requires that any distributions received from the IRA flow directly to the trust’s individual beneficiaries. This structure allows the individual beneficiaries to be treated as the designated beneficiaries for RMD purposes, potentially enabling them to use their life expectancy or the 10-year rule. An “accumulation trust” permits the trustee to retain distributions within the trust. In this scenario, the trust itself is treated as the beneficiary, which can lead to faster distribution requirements, sometimes adhering to the 5-year rule or the life expectancy of the oldest trust beneficiary if “look-through” rules apply.

If a charity is named as the beneficiary, the IRA assets are distributed directly to the organization. These distributions are tax-free to the charity, as qualified charities are exempt from income tax. When the deceased’s estate is the beneficiary, the IRA funds become part of the probate estate. This often means the funds must be distributed more quickly, sometimes within five years if the original owner died before their required beginning date for RMDs, or over the original owner’s remaining life expectancy if they died after. Estate beneficiaries do not have the same deferral opportunities as individual beneficiaries.

Navigating Required Minimum Distributions

Required Minimum Distributions (RMDs) are specific amounts that must be withdrawn from inherited IRAs annually or by a set deadline to avoid penalties. The rules for RMDs from inherited IRAs vary based on the beneficiary type and the original account owner’s date of death.

For non-eligible designated beneficiaries, the “10-year rule” applies if the original IRA owner died on or after January 1, 2020. Under this rule, the entire balance of the inherited IRA must be distributed by December 31st of the year containing the 10th anniversary of the original owner’s death. While the total amount must be withdrawn by this deadline, annual distributions are not explicitly required within the 10-year period unless the original owner had already begun taking RMDs. If the original owner was already subject to RMDs, the beneficiary must continue taking annual RMDs based on the original owner’s remaining life expectancy for years 1-9, with the full remaining balance due by the end of the 10th year.

Eligible Designated Beneficiaries (EDBs) may take distributions over their life expectancy. For these beneficiaries, annual RMDs are calculated using the beneficiary’s life expectancy, based on IRS life expectancy tables. Spousal beneficiaries who choose not to roll over the IRA into their own name also have the option to take distributions based on their life expectancy.

The “stretch IRA” allowed beneficiaries to spread distributions over their lifetime, maximizing tax-deferred growth. This option is no longer available for most beneficiaries of IRAs inherited after 2019. The 10-year rule effectively replaced the stretch provision for many non-spouse beneficiaries.

Failing to take a required minimum distribution can result in a penalty. The IRS imposes an excise tax of 25% on the amount that should have been distributed but was not. This penalty may be reduced to 10% if the missed distribution is corrected promptly and the failure was due to reasonable cause.

The start date for RMDs varies based on the beneficiary type. For non-spouse beneficiaries subject to the 10-year rule, the 10-year period begins the year following the original owner’s death. For EDBs electing life expectancy distributions, RMDs begin by December 31st of the year following the original owner’s death. For a minor child who is an EDB, the life expectancy rule applies until they reach the age of majority (usually 21), at which point the 10-year rule begins, requiring full distribution by the end of the year containing the 10th anniversary of reaching that age.

Tax Implications of Inherited IRA Distributions

Understanding the tax implications of inherited IRA distributions is important for managing these assets. The tax treatment varies based on the type of IRA inherited and the nature of the distributions. Beneficiaries must account for these taxes when planning their withdrawals.

Distributions from a Traditional Inherited IRA are taxed as ordinary income to the beneficiary. This means the money withdrawn is added to the beneficiary’s gross income for the year and is subject to their marginal income tax rate. If the original owner made non-deductible contributions to their Traditional IRA, a portion of the distributions may be tax-free, representing the “basis” or after-tax contributions. This non-taxable portion is calculated using specific IRS rules.

For a Roth Inherited IRA, qualified distributions are tax-free to the beneficiary. A distribution is considered qualified if the original Roth IRA account was established for at least five years, a period known as the “five-year rule.” Even if the beneficiary is under age 59½, qualified distributions from an inherited Roth IRA are exempt from income tax and the 10% early withdrawal penalty.

Inherited IRAs are included in the deceased’s taxable estate for estate tax purposes. Beneficiaries of inherited IRAs may be eligible for an income tax deduction for estate tax paid on “Income in Respect of a Decedent” (IRD). This deduction helps to mitigate the impact of both estate tax and income tax on the same inherited assets.

When distributions are taken from an inherited IRA, federal income tax may be withheld from the amount distributed. Beneficiaries can choose the amount of tax to be withheld, or they can opt out of withholding entirely and pay estimated taxes. Distributions from inherited IRAs are reported to the IRS on Form 1099-R, which details the amount distributed and any taxes withheld. This form is sent to the beneficiary and the IRS, facilitating proper tax reporting.