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

An inherited Individual Retirement Account (IRA) is a financial asset passed to a beneficiary after the original owner’s death. This type of account presents unique considerations for recipients. Understanding the rules and options for an inherited IRA is important for beneficiaries to manage these assets effectively.

Handling an Inherited IRA as a Spousal Beneficiary

When a spouse inherits an IRA, they have flexible options. One choice is to treat the inherited IRA as their own. This allows the spouse to roll over assets into an existing IRA or establish a new IRA in their own name, making it their personal retirement account. Once funds are in their own IRA, the spouse can contribute to it, and their required minimum distributions (RMDs) will begin based on their age.

Alternatively, a spouse can remain a beneficiary of the inherited IRA, keeping it separate from their own retirement accounts. In this scenario, the spouse can delay distributions until the deceased spouse would have reached age 73, or begin RMDs based on their own life expectancy. This choice offers a deferral of distributions, potentially providing more time for assets to grow tax-deferred. The decision depends on the spouse’s age, financial needs, and long-term planning goals.

A spouse also has the option to disclaim the inherited IRA, refusing to accept ownership. Disclaiming an inheritance results in assets passing to contingent beneficiaries, as if the disclaiming spouse had predeceased the original owner. This action may be considered for estate planning, such as reducing the spouse’s taxable estate or allowing younger generations to receive assets directly. A disclaimer must be in writing and delivered to the IRA custodian within nine months of the original owner’s death.

Handling an Inherited IRA as a Non-Spousal Beneficiary

Non-spousal beneficiaries inheriting an IRA face different rules than spouses. For most, the 10-year rule applies, mandating that the entire inherited IRA balance must be distributed by the end of the tenth year following the original owner’s death.

Under the 10-year rule, annual RMDs are not mandated during the 10-year period if the original owner died before their required beginning date for RMDs. However, if the original owner died on or after their required beginning date, the non-spousal beneficiary must take annual RMDs based on the deceased owner’s life expectancy for years one through nine. The entire remaining balance must still be distributed by the end of the tenth year. This distinction helps beneficiaries avoid penalties for missed distributions.

Certain individuals are Eligible Designated Beneficiaries (EDBs) and are exempt from the 10-year rule, stretching distributions over their own life expectancy. EDBs include disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased owner. Minor children of the original owner are also EDBs, stretching distributions until they reach the age of majority (typically 21). At that point, the remaining balance becomes subject to the 10-year rule.

If a trust is named as the beneficiary, distribution rules depend on whether it qualifies as a “look-through” trust. For a look-through trust, the trust’s beneficiaries are treated as designated beneficiaries, and the 10-year rule or EDB exceptions may apply. If a charity is named, it receives the full amount free of income tax.

Tax Implications of Inherited IRA Distributions

Distributions from an inherited traditional IRA are subject to ordinary income tax in the year received by the beneficiary. The money distributed is added to the beneficiary’s other taxable income and taxed at their marginal rate. The original owner’s contributions and earnings were tax-deferred, so the beneficiary inherits this tax liability.

For an inherited Roth IRA, qualified distributions are tax-free and penalty-free for the beneficiary. A distribution is qualified if made after a five-year period since the first Roth IRA contribution by the original account holder. If the five-year rule has not been met, earnings may be subject to ordinary income tax. Contributions to a Roth IRA are made with after-tax dollars, so those amounts are never taxed upon distribution.

Beneficiaries do not face the 10% early withdrawal penalty that applies to IRA distributions taken before age 59½. Distributions from an inherited IRA are exempt from this penalty, regardless of the beneficiary’s age. This exemption applies to both traditional and Roth accounts, providing flexibility for beneficiaries who may need access to funds sooner.

Distributions from an inherited IRA are reported to the IRS on Form 1099-R, issued by the IRA custodian. This form details the amount of the distribution and its taxability. Beneficiaries must report these distributions on their federal income tax return as taxable income if from a traditional IRA or non-qualified Roth IRA earnings. Distributions may also be subject to state income taxes, depending on the beneficiary’s state of residence.

Steps to Access an Inherited IRA

To access an inherited IRA, contact the custodian of the deceased individual’s IRA. This custodian could be a bank, brokerage firm, or other financial institution. Beneficiaries should inquire about the procedures and required forms for claiming the assets.

The IRA custodian will require documentation to verify the beneficiary’s identity and the original owner’s death. Documents requested include a certified copy of the death certificate, proof of identity (such as a driver’s license or passport), and the beneficiary designation form from the deceased’s IRA. This form officially names the individual or entity entitled to inherit the assets.

Once documentation is submitted and verified, the custodian will assist the beneficiary in establishing an inherited IRA account, sometimes called a “beneficiary IRA.” This account is titled to reflect its inherited nature, typically in the name of the deceased owner for the benefit of the beneficiary. This formally transfers the assets into the beneficiary’s control under the inherited IRA rules.

After the inherited IRA account is established, the beneficiary can initiate distributions according to applicable rules. The custodian will provide forms or instructions for requesting withdrawals, which can be taken as a lump sum or periodic payments. It is important to consider the tax implications and distribution deadlines before requesting funds.