What Should I Do With an Inherited IRA?

Inheriting an Individual Retirement Account (IRA) represents a significant financial event, often accompanied by complex rules and important decisions. These assets are subject to specific regulations, differing from other inherited property. Understanding the available options is crucial for beneficiaries to manage these funds effectively, maximize their value, and avoid potential tax penalties. This guide clarifies inherited IRA intricacies, helping you make informed financial choices.

Determining Your Beneficiary Category

The initial step in managing an inherited IRA involves identifying your specific beneficiary category, as this classification dictates the applicable distribution rules. A spousal beneficiary is the surviving spouse of the deceased IRA owner, typically offered the most flexible options regarding inherited IRA assets.

Conversely, a non-spousal beneficiary refers to any individual other than the surviving spouse. The SECURE Act of 2019 introduced significant changes to distribution requirements for this group.

An Eligible Designated Beneficiary (EDB) can stretch distributions over their life expectancy. This category includes:
Disabled or chronically ill individuals.
Minor children of the deceased IRA owner (until they reach the age of majority).
Individuals not more than 10 years younger than the deceased.
Surviving spouses who choose not to treat the IRA as their own.

A Non-Eligible Designated Beneficiary (Non-EDB) includes all other non-spousal beneficiaries, such as adult children, siblings, or friends who do not meet the EDB criteria. These beneficiaries generally face stricter distribution timelines under current law due to the SECURE Act’s changes.

Furthermore, entities like estates or trusts can also be named as beneficiaries, typically referred to as non-person beneficiaries. These types of beneficiaries often have the least flexible distribution options and may lead to faster required distributions of the inherited assets.

Spousal Beneficiary Choices

Spousal beneficiaries possess several distinct and advantageous choices when inheriting an IRA, offering considerable flexibility. One common and often preferred option is to treat the inherited IRA as your own. This involves either rolling over the funds into your existing IRA, transferring them to a new IRA established in your name, or simply retitling the inherited account into your own name. This election allows the surviving spouse to delay Required Minimum Distributions (RMDs) until their own RMD age (currently 73), treating the account as their own.

Another choice for a surviving spouse is to keep the account as an inherited IRA, sometimes referred to as a beneficiary IRA. Under this option, the spouse begins taking RMDs based on their own life expectancy. A significant advantage of this approach is that distributions can start earlier than age 59½ without incurring the typical 10% early withdrawal penalty that applies to personal IRAs. This can be particularly beneficial if the surviving spouse needs access to the funds before reaching the traditional distribution age for their own retirement accounts.

If the original IRA owner had begun RMDs, the spouse can continue distributions based on the deceased’s schedule or their own, allowing for strategic planning. A less common, but available, option is a disclaimer of interest, where a spouse may formally decline the inheritance. If this occurs, the IRA typically passes to the contingent beneficiaries named by the original owner, which can be part of broader estate planning strategies.

Non-Spousal Beneficiary Choices

Non-spousal beneficiaries face distinct and generally more stringent rules for inherited IRAs, especially after the SECURE Act. For most Non-Eligible Designated Beneficiaries (Non-EDBs), the primary rule is the 10-year rule. This mandates the entire balance be distributed by December 31st of the calendar year containing the 10th anniversary of the original IRA owner’s death (e.g., if death in 2025, depleted by Dec 31, 2035).

Under the 10-year rule, if the original IRA owner died before their required beginning date (RBD) for RMDs, the beneficiary has flexibility to withdraw funds at any point within the decade, or wait until the final year. The entire balance must be withdrawn by the deadline.

If the original owner died on or after their RBD, annual RMDs are required for years 1-9, with the full balance still needing to be withdrawn by the end of the 10th year. This rule applies to both inherited Traditional and Roth IRAs, differing only in tax treatment. Failure to fully distribute the account by the 10-year deadline can result in a significant penalty, typically 25% of the amount that should have been distributed, though it may be reduced to 10% if corrected promptly.

Certain non-spousal beneficiaries qualify as Eligible Designated Beneficiaries (EDBs) and are exempt from the strict 10-year rule, instead able to utilize the life expectancy payout method. EDBs can stretch distributions over their own life expectancy, providing a more gradual distribution schedule.

For non-person beneficiaries, such as estates or trusts, the distribution rules can be less flexible. If the original IRA owner died before their RBD for RMDs, the 5-year rule often applies, requiring full distribution within five years. If the owner died on or after their RBD, the distributions are typically based on the deceased owner’s remaining life expectancy. Trust terms can influence rule application, requiring careful review to ensure compliance and avoid adverse tax consequences.

Navigating Tax Implications

Understanding tax implications is a key aspect of managing an inherited IRA, regardless of your beneficiary category. Distributions from a Traditional Inherited IRA are generally taxable as ordinary income to the beneficiary in the year they are received. Withdrawn amounts are added to your gross income and taxed at your marginal income tax rate. Strategic withdrawal timing, like spreading distributions over the 10-year period or taking them in lower-income years, can help manage the tax burden.

In contrast, qualified distributions from a Roth Inherited IRA are typically tax-free and penalty-free. For a distribution to be qualified, the original Roth IRA must have been established for at least five years before the distribution is made. This “five-year rule” applies to the original owner’s Roth IRA. If the original account was less than five years old, earnings portions might be taxable until that period is met. Once met, beneficiaries can withdraw earnings and contributions without federal income tax.

Inherited IRAs are generally included in the deceased’s taxable estate for federal estate tax purposes, though most estates do not reach the exemption threshold. While beneficiaries typically do not pay estate tax directly, they may be eligible for an “income in respect of a decedent” (IRD) deduction if both estate and income tax apply. State income tax rules may also apply, varying by jurisdiction. Consulting a tax professional can provide tailored guidance.