What to Do With an Inherited IRA From a Parent

Inheriting an Individual Retirement Account (IRA) from a parent requires careful consideration due to specific regulations. Navigating the process involves identifying your beneficiary status, comprehending distribution requirements, and recognizing the tax treatment of withdrawals.

Determining Your Beneficiary Category

Your relationship to the deceased parent determines your beneficiary category, which dictates the rules for your inherited IRA. These categories are crucial for understanding the distribution timelines and options available to you.

A Spousal Beneficiary is the surviving spouse of the original IRA owner. Spouses generally have the most flexible options for handling an inherited IRA.

An Eligible Designated Beneficiary (EDB) includes specific non-spouse individuals who qualify for extended distribution periods. This category encompasses the deceased IRA owner’s minor child, an individual who is disabled or chronically ill as defined by IRS criteria, and any individual who is not more than 10 years younger than the original IRA owner. A minor child is an EDB until age 21, when different rules apply.

Most non-spouse beneficiaries, such as adult children, siblings, or other relatives who do not meet the EDB criteria, fall into the Designated Beneficiary category. These individuals are subject to a specific set of rules, particularly regarding the timeline for distributing the inherited IRA assets. The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 significantly altered the distribution rules for this group.

Finally, a Non-Designated Beneficiary refers to entities that are not individuals, such as an estate, a trust without specific look-through provisions, or a charity. When an IRA is inherited by a non-designated beneficiary, the distribution rules are generally more restrictive, offering fewer options for extending the tax-deferred growth of the assets.

Understanding Distribution Options and Rules

Distribution rules for an inherited IRA depend on your beneficiary category, with different timelines and choices available. Adhering to these regulations avoids penalties.

For Spousal Beneficiaries, several options provide considerable flexibility. A surviving spouse can choose to treat the inherited IRA as their own, effectively rolling it over into an existing or new IRA in their name. This allows them to manage the account as if they were the original owner, including delaying required minimum distributions (RMDs) until they reach their own RMD age, which is currently 73. Alternatively, a spouse can open an inherited IRA and take distributions based on the deceased spouse’s age or their own life expectancy.

Eligible Designated Beneficiaries (EDBs) generally have the option to “stretch” distributions over their life expectancy, similar to rules that existed before 2020. For example, a minor child can take distributions based on their life expectancy until age 21, after which remaining funds must be distributed within 10 years. Disabled or chronically ill individuals, and those not more than 10 years younger than the original owner, can stretch distributions over their life expectancy.

Most Designated Beneficiaries, who are non-spouses and not EDBs, are subject to the 10-year rule for IRAs inherited after 2019. This rule requires that the entire inherited IRA balance must be distributed by December 31 of the 10th calendar year following the year of the parent’s death. If the original IRA owner had already started RMDs, the designated beneficiary must continue annual RMDs during the 10-year period. If the original owner died before their RMD beginning date, annual RMDs are not required within the 10-year period, but the entire balance must still be distributed by the end of the 10th year.

For Non-Designated Beneficiaries (e.g., estates or trusts), distribution rules are more stringent. If the original IRA owner died before their required beginning date for RMDs, the assets generally must be distributed within five years of the owner’s death. If the original owner died on or after their required beginning date, distributions may continue over the deceased owner’s remaining life expectancy, though rules are complex for non-individual entities.

Tax Implications of Distributions

Distributions from an inherited IRA carry specific tax implications. The tax treatment depends on whether the account is a traditional or Roth IRA.

Distributions from an inherited traditional IRA are generally taxed as ordinary income to the beneficiary in the year they are received. Distributions are added to your other income and taxed at your federal income tax rates. State income taxes may also apply to these distributions, depending on the state where the beneficiary resides.

Inherited Roth IRA distributions are generally tax-free if the original Roth IRA was established at least five years before the owner’s death. If the five-year holding period has not been met, the earnings portion might be taxed, though contributions can be withdrawn tax-free. Even if the original owner’s Roth IRA was less than five years old, distributions become fully tax-free once the five-year period from the original establishment date is satisfied.

The 10% early withdrawal penalty, typically applied to personal IRA withdrawals before age 59½, generally does not apply to inherited IRA distributions. This exemption applies regardless of the beneficiary’s age at the time of withdrawal. Financial institutions report inherited IRA distributions to the IRS on Form 1099-R, and beneficiaries must include the taxable portion on their income tax returns.

Establishing and Managing the Inherited IRA

After understanding distribution rules and tax implications, the next step involves establishing and managing the inherited IRA. This process begins with informing the financial institution holding the deceased parent’s account.

First, inform the financial institution (custodian) holding the deceased parent’s IRA about their passing. This involves providing a death certificate and other documentation. The custodian will then guide you through their procedures.

Following notification, open a new inherited IRA account, often called a “beneficiary IRA.” This account is distinct from a personal IRA and must be titled correctly to reflect its inherited status. A common titling format includes the deceased owner’s name, followed by “deceased,” and then “for the benefit of” (FBO) the beneficiary’s name (e.g., “John Doe (deceased) FBO Jane Smith, Beneficiary”). Accurate titling is important, as incorrect titling can lead to unintended taxable distributions.

Assets from the deceased parent’s original IRA are then transferred directly into this new inherited IRA account. This is typically a trustee-to-trustee transfer, meaning funds move directly between financial institutions without passing through the beneficiary’s hands. This direct transfer helps avoid deemed distributions that could trigger immediate taxation. Additional contributions cannot be made to an inherited IRA.

If subject to required minimum distributions (RMDs), calculate and take these withdrawals from the inherited account. The financial institution can assist in calculating the RMD amount based on your beneficiary category and account value. Initiate withdrawals by required deadlines to avoid substantial penalties. Maintain accurate records of all communications, statements, and distributions for tax reporting and future reference.