What Is the Best Thing to Do With an Inherited IRA?

Inheriting an Individual Retirement Arrangement (IRA) involves specific rules and choices that influence its long-term financial impact. Beneficiaries must understand these provisions to navigate options.

Understanding Inherited IRAs

An inherited IRA is a retirement account passed to a beneficiary after the original owner’s death. It is subject to specific rules for distributions and taxation, differing from personal IRAs. The beneficiary’s classification significantly determines available options and withdrawal timelines.

Beneficiaries are generally categorized into three main groups: spousal beneficiaries, non-spousal beneficiaries, and non-individual beneficiaries. Spousal beneficiaries are the surviving spouses of the deceased IRA owner, who typically have the most flexible options. Non-spousal beneficiaries include designated beneficiaries, such as children, siblings, or other named individuals, and eligible designated beneficiaries, who meet specific criteria for extended distribution periods. Non-individual beneficiaries include entities like estates, charities, or certain trusts.

The type of inherited IRA, traditional or Roth, influences its tax treatment. Traditional inherited IRAs have tax-deferred growth, with distributions taxed as ordinary income. Roth inherited IRAs grow tax-free, and qualified distributions are generally tax-free. This distinction stems from original contributions and their tax treatment.

Primary Options for Inheriting an IRA

Upon inheriting an IRA, beneficiaries face several primary options with distinct implications for accessing funds and future tax obligations. The choice depends on the beneficiary’s relationship to the deceased and their financial planning objectives.

A surviving spouse has unique flexibility, able to treat the inherited IRA as their own. This can involve rolling over funds into an existing or new IRA, or redesignating the inherited IRA. When a spouse treats the IRA as their own, they become subject to owner rules, including taking required minimum distributions (RMDs) based on their own age and potentially making new contributions.

Another common option for non-spousal beneficiaries is to transfer assets to an inherited IRA. This involves establishing a new account titled to indicate the original owner’s death and the beneficiary’s status. Funds in an inherited IRA cannot be commingled with personal retirement accounts, and contributions are not permitted. This account maintains the original IRA’s tax status while subjecting distributions to specific rules.

Taking a lump sum distribution is an option for all beneficiary types. While providing immediate access to funds, it can have significant tax consequences. For a traditional IRA, the entire distribution is typically added to the beneficiary’s gross income, potentially pushing them into a higher tax bracket. This immediate taxation can substantially reduce the net amount received.

Finally, a beneficiary may choose to disclaim the inherited IRA. A qualified disclaimer means the beneficiary formally refuses the inheritance, allowing assets to pass to contingent beneficiaries. For a disclaimer to be qualified under federal tax law, it must be in writing, made within nine months of the IRA owner’s death, and the disclaiming beneficiary must not have received any benefits. This option is often considered for estate planning or to avoid unwanted tax burdens.

Required Minimum Distributions for Inherited IRAs

Required Minimum Distributions (RMDs) are mandatory annual withdrawals from most inherited IRAs. These rules ensure tax-deferred savings are eventually taxed, varying significantly based on the beneficiary’s relationship to the deceased and the original owner’s age at death. Understanding these rules helps avoid penalties.

The SECURE Act introduced significant changes to RMD rules for inherited IRAs, particularly for non-spousal designated beneficiaries. For most individuals inheriting an IRA from an owner who died after December 31, 2019, the 10-year rule applies. This requires the entire inherited IRA balance to be distributed by the end of the tenth calendar year following the original owner’s death.

There are specific exceptions to the 10-year rule for certain individuals known as eligible designated beneficiaries. These include surviving spouses, minor children of the deceased IRA owner, individuals who are disabled or chronically ill, and individuals who are not more than 10 years younger than the deceased IRA owner. These beneficiaries may still be able to stretch RMDs over their life expectancy, offering more flexibility and potential for continued tax-deferred growth. For a minor child, the 10-year rule generally applies once they reach the age of majority.

For other designated beneficiaries subject to the 10-year rule, the requirement for annual RMDs during the 10-year period depends on whether the original IRA owner died before or after their required beginning date (RBD). If the original owner died before their RBD, no RMDs are required during the 10-year period; the entire balance just needs to be withdrawn by the end of the tenth year. However, if the original owner died on or after their RBD, then annual RMDs are required during the 10-year period, with the remaining balance distributed by the end of the tenth year.

Non-designated beneficiaries, such as estates or non-qualified trusts, follow different RMD rules. If the original IRA owner died before their RBD, the entire account balance must be distributed by the end of the fifth calendar year following death. If the owner died on or after their RBD, distributions must continue at least as rapidly as they would have been made had the owner lived. Failing to take a required minimum distribution can result in a penalty, typically an excise tax of 25% of the amount not distributed. This penalty may be reduced to 10% if corrected promptly.

Tax Implications of Inherited IRA Distributions

Distributions from inherited IRAs carry specific tax implications for financial planning. Tax treatment largely depends on whether the inherited account is a traditional or Roth IRA. Understanding these differences is important for accurate tax reporting.

For traditional inherited IRAs, distributions are generally taxable income when received. These amounts are taxed as ordinary income at the beneficiary’s marginal income tax rate. Financial institutions typically report these distributions on Form 1099-R. Distributions due to death are exempt from the 10% early withdrawal penalty, regardless of the beneficiary’s age.

In contrast, qualified distributions from an inherited Roth IRA are generally received tax-free at the federal level. A distribution is considered qualified if it is made after a five-year period has passed since the original owner’s first contribution to any Roth IRA. This five-year rule applies to the original owner’s Roth IRA, not to the beneficiary’s holding period. If the distribution is not qualified, a portion of the earnings may be taxable.

State income tax rules may also apply to inherited IRA distributions, and these can vary. Beneficiaries should consult state tax regulations where they reside, as some states may fully or partially tax these distributions. The combined federal and state income tax liability can be a significant factor when deciding on distribution strategies.

It is important to distinguish between income tax and estate tax. While an inherited IRA’s value is included in the deceased’s gross estate for federal estate tax purposes, most estates do not owe federal estate tax due to high exemption limits. The estate tax is typically paid by the estate itself, if applicable, before assets are distributed to beneficiaries, and is separate from the income tax levied on distributions. There is generally no step-up in basis for inherited traditional IRAs, meaning the full distribution is typically taxable as income unless the original owner made non-deductible contributions.