What You Should Do With an Inherited IRA

An inherited Individual Retirement Account (IRA) presents a unique financial situation. When an IRA owner passes away, assets transfer to a designated beneficiary. Understanding these regulations is important for proper management and to avoid unintended tax consequences. Rules vary based on the beneficiary’s relationship and the IRA type.

Understanding Beneficiary Designations and Account Types

The IRS categorizes inherited IRA beneficiaries into distinct groups: Eligible Designated Beneficiaries, Designated Beneficiaries, and Non-Designated Beneficiaries. Classification determines distribution options and withdrawal timelines.

An Eligible Designated Beneficiary (EDB) qualifies for flexible distribution rules. This group includes:
The surviving spouse.
A minor child of the original owner.
A disabled individual.
A chronically ill individual.
Any other individual not more than 10 years younger than the deceased owner.
EDBs generally stretch distributions over their own life expectancy.

A Designated Beneficiary (DB) is any individual named by the IRA owner who does not meet EDB criteria. This typically includes adult children, siblings, or friends more than 10 years younger than the deceased. For deaths after 2019, most DBs are subject to a 10-year distribution rule.

A Non-Designated Beneficiary refers to an entity (e.g., an estate, charity, or certain trusts). When an IRA is inherited by a Non-Designated Beneficiary, distribution rules are more restrictive. These beneficiaries cannot stretch distributions over a lifetime, lacking a measurable life expectancy.

The type of IRA inherited plays a significant role in determining rules and tax implications. A Traditional IRA is funded with pre-tax contributions, meaning distributions are subject to ordinary income tax. Funds grow tax-deferred, with taxes paid only upon withdrawal.

In contrast, a Roth IRA is funded with after-tax contributions, and qualified distributions are tax-free. Contributions and earnings can be withdrawn without income tax, provided a five-year holding period is met. Understanding these differences is important for navigating distribution and tax rules.

Distribution Rules for Different Beneficiaries

Rules governing inherited IRA distributions vary considerably based on beneficiary classification and IRA type. These rules dictate when and how much money must be withdrawn, impacting long-term asset growth. The SECURE Act of 2019 introduced substantial changes, particularly for non-spouse beneficiaries.

A surviving spouse who inherits an IRA has flexible options. One common choice is to treat the inherited IRA as their own, by rolling funds into an existing IRA or retitling the account. This allows the spouse to defer Required Minimum Distributions (RMDs) until their own required beginning date, currently age 73. This option enables continued tax-deferred growth for Traditional IRAs or tax-free growth for Roth IRAs.

Alternatively, a surviving spouse can remain as the inherited IRA’s beneficiary. If chosen, the spouse may take distributions based on their own life expectancy, or defer RMDs until the deceased spouse would have reached their required beginning date. This is suitable if the surviving spouse is younger than 59½ and wishes to access funds without incurring the 10% early withdrawal penalty that would apply to their own IRA.

For non-spouse Designated Beneficiaries, the SECURE Act significantly altered rules for deaths after 2019. Most are now subject to the 10-year rule, requiring the entire inherited IRA balance to be distributed by December 31 of the tenth year following the original owner’s death.

A nuance depends on whether the original IRA owner died before or after their Required Beginning Date (RBD) for RMDs. If the owner died after their RBD, the non-spouse Designated Beneficiary generally takes annual RMDs in years one through nine, with the remaining balance distributed by the end of the tenth year. If the owner died before their RBD, annual RMDs are typically not required during the 10-year period, offering flexibility to choose when to take distributions, provided the account is empty by the deadline.

Eligible Designated Beneficiaries (EDBs), other than surviving spouses, can still stretch distributions over their life expectancy. This allows for smaller, annual RMDs based on the beneficiary’s life expectancy, enabling inherited assets to continue growing tax-deferred or tax-free longer. For a minor child who is an EDB, this rule applies only until they reach the age of majority (usually 21). Once the minor child reaches this age, the 10-year rule typically applies, requiring the remaining balance to be distributed by the end of the tenth year after they reach majority.

For Non-Designated Beneficiaries (e.g., estates or charities), distribution rules are generally more stringent. If the original IRA owner died before their RBD, the inherited IRA typically falls under the 5-year rule, meaning the entire account balance must be distributed by the end of the fifth year following the owner’s death. If the original owner died on or after their RBD, distributions can generally be stretched over the original owner’s remaining life expectancy, sometimes called the “ghost” life expectancy.

Tax Considerations for Inherited IRAs

Understanding the tax implications of inherited IRA distributions is as important as the distribution rules. Tax treatment varies based on whether the inherited account is a Traditional IRA or a Roth IRA. These considerations affect the net amount a beneficiary receives and can influence withdrawal strategies.

Distributions from an inherited Traditional IRA are taxable as ordinary income to the beneficiary in the year received. Withdrawals are added to the beneficiary’s other income and taxed at their marginal income tax rate. Unlike personal IRA withdrawals before age 59½, inherited IRA distributions are not subject to the 10% early withdrawal penalty, regardless of age.

For an inherited Roth IRA, distributions are generally tax-free, provided the original Roth IRA account was established at least five years before the owner’s death. If this five-year holding period is not met, the earnings portion of distributions may be subject to income tax, while contributions remain tax-free. No 10% early withdrawal penalty typically applies, even if earnings are taxable.

Beneficiaries often have flexibility within prescribed distribution periods to manage tax liability. For example, under the 10-year rule, a Traditional IRA beneficiary can strategically plan withdrawals to avoid higher tax brackets. Taking larger distributions in years with lower overall income can help minimize the total tax burden.

Inherited IRAs are generally included in the deceased owner’s taxable estate for federal estate tax purposes. However, the federal estate tax exemption is substantial, meaning only very large estates are typically subject to this tax. If estate taxes were paid on the inherited IRA, the beneficiary may be eligible for an income tax deduction for the portion of estate taxes attributable to the IRA (an “income in respect of a decedent” deduction). State income taxes may also apply, depending on the beneficiary’s state of residence.

Administering an Inherited IRA

Once distribution rules and tax implications are understood, practical steps for administering an inherited IRA come into focus. This involves retitling the account, understanding the process for requesting distributions, and addressing any Required Minimum Distributions (RMDs) the original owner may have been required to take. These actions ensure IRS compliance and allow the beneficiary to access funds.

The first step is to retitle the inherited IRA account. This involves contacting the financial institution where the IRA is held and completing paperwork. The account is usually retitled as “[Deceased Owner’s Name] FBO [Beneficiary’s Name] Inherited IRA,” distinguishing it from any personal IRAs the beneficiary may already own.

Requesting distributions from an inherited IRA involves submitting specific forms to the financial institution. These forms require the beneficiary to specify the amount and frequency of withdrawals. The financial institution processes the request and issues funds, usually via direct deposit or check. Keep accurate records for tax reporting.

If the original IRA owner had begun taking Required Minimum Distributions (RMDs) before death, and had not taken the RMD for the year of death, the beneficiary is generally responsible for taking that final RMD. This RMD must be taken by December 31 of the year the original owner died. Failure to take this RMD can result in penalties.

For beneficiaries subject to ongoing RMDs (such as Eligible Designated Beneficiaries using the life expectancy method, or Designated Beneficiaries where the original owner died after their RBD), these distributions must be calculated and withdrawn annually. The financial institution holding the inherited IRA can assist with these calculations or provide resources for determining the correct RMD amount each year. Adhering to the RMD schedule avoids potential penalties.