You’ve Inherited an IRA. Now What?

Inheriting an Individual Retirement Account (IRA) can introduce complexity. Understanding the options and obligations that come with an inherited IRA is important for managing these assets. This guide will help navigate the steps and considerations to handle an inherited IRA.

Determining Your Beneficiary Category

The first step when inheriting an IRA involves identifying your beneficiary category, as this dictates the specific rules and distribution options available. Beneficiary types include a spouse beneficiary, a non-spouse designated beneficiary, and a non-designated beneficiary, such as an estate or trust. Each category has distinct implications for how the inherited assets must be handled.

A spouse beneficiary typically possesses the most flexibility. They can choose to treat the IRA as their own, transfer the funds into their existing IRA, or transfer them into an inherited IRA in their name. This often allows for continued tax-deferred growth and the ability to delay required minimum distributions (RMDs) until they reach their own RMD age, currently 73.

A non-spouse designated beneficiary is an individual named by the original IRA owner, such as a child, sibling, or friend. Most non-spouse designated beneficiaries are now subject to the 10-year rule, which requires the entire inherited IRA balance to be distributed by the end of the tenth calendar year following the original owner’s death.

Exceptions to the 10-year rule exist for eligible designated beneficiaries (EDBs). This group includes individuals who are disabled, chronically ill, or not more than 10 years younger than the deceased IRA owner. Minor children of the original account holder also qualify as EDBs, but special rules apply once they reach the age of majority, typically age 21.

A non-designated beneficiary is typically an entity without a life expectancy, such as an estate, a trust, or a charity. When an IRA is inherited by one of these entities, the distribution rules are generally the most restrictive. Understanding which category applies is foundational for determining subsequent distribution strategies and tax planning.

Understanding Your Distribution Options

Once your beneficiary category is established, the next step involves understanding the specific rules and timelines for withdrawing funds from the inherited IRA. These options vary significantly based on your beneficiary status and whether the original IRA owner had already begun taking their own required minimum distributions (RMDs).

For spouse beneficiaries, options provide considerable flexibility. A common choice is to roll over the inherited funds into their own IRA, allowing them to treat the account as if it were always theirs. This enables them to delay RMDs until they reach their own RMD age, currently 73, and to name their own beneficiaries. Alternatively, a spouse can transfer the assets into an inherited IRA in their name, which may be beneficial if they are under age 59½ and need access to funds without incurring the 10% early withdrawal penalty. In this case, RMDs would typically begin based on the deceased spouse’s age or their own, depending on which provides a more favorable outcome.

Non-spouse designated beneficiaries, including most adult children, are generally subject to the 10-year rule for IRAs inherited after December 31, 2019. If the original IRA owner died after their RMDs had begun, the beneficiary must take annual RMDs for years one through nine within the 10-year period, with the full balance withdrawn by the end of the tenth year. If the original owner died before their RMDs began, annual distributions are not required within the 10-year period, but the entire account must still be empty by the end of the tenth year.

Eligible designated beneficiaries (EDBs) can generally stretch distributions over their own life expectancy. This allows for smaller, annual RMDs, which can prolong the tax-deferred growth of the inherited assets. For a minor child who is an EDB, they can take distributions based on their life expectancy until they reach the age of majority, typically 21, at which point the 10-year rule generally applies to the remaining balance.

For non-designated beneficiaries, such as an estate or charity, distribution rules are more constrained. If the original owner died before their RMDs began, the entire account must generally be distributed by the end of the fifth year following the owner’s death. If the original owner died after their RMDs began, distributions must continue over the deceased’s remaining life expectancy. The general principle is to ensure funds are distributed according to the applicable timeline for your beneficiary type.

Tax Implications of Inherited IRA Distributions

Understanding the tax implications of inherited IRA distributions is important for financial planning. The tax treatment depends primarily on whether the inherited account is a traditional IRA or a Roth IRA, and whether the original owner made after-tax contributions. Proper reporting of these distributions is also necessary.

Distributions from an inherited traditional IRA are generally taxed as ordinary income to the beneficiary in the year received. These withdrawals are added to your other income and taxed at your marginal income tax rate. If the original IRA owner made non-deductible (after-tax) contributions, a portion of the distribution might be tax-free, tracked on IRS Form 8606.

Qualified distributions from an inherited Roth IRA are generally tax-free. A distribution is qualified if the Roth IRA has been open for at least five years, starting from January 1 of the year the original owner first contributed to any Roth IRA. Even if the five-year period has not been met, the contributions portion of the Roth IRA is generally tax-free, though earnings might be taxable.

The 10% early withdrawal penalty, which typically applies to IRA withdrawals before age 59½, does not apply to inherited IRA distributions. This exemption holds true regardless of the beneficiary’s age or the original owner’s age at the time of death.

While the IRA’s value is included in the deceased’s estate for federal estate tax purposes, most estates do not owe federal estate tax due to high exemption limits. Income tax on inherited IRA distributions is separate from any potential estate tax. Financial institutions will issue Form 1099-R to the beneficiary for any distributions taken, reporting the gross distribution, taxable amount, and any federal taxes withheld. This form is used for tax reporting.

Claiming the Inherited IRA and Managing Distributions

After understanding your beneficiary category, distribution options, and tax implications, the next step involves claiming the inherited IRA and managing subsequent distributions. This procedural phase requires direct interaction with the financial institution holding the IRA and attention to documentation and titling.

The initial action is to contact the financial institution where the deceased’s IRA was held. Inform them of the account holder’s death and your status as a beneficiary. They will provide specific instructions and forms necessary to process the inheritance.

You will generally provide certain documentation, including a certified copy of the death certificate, your government-issued identification, and a completed beneficiary claim form. If the IRA is inherited through a trust, relevant trust documents will also be needed. Providing all requested documents promptly helps expedite the process.

Once paperwork is submitted, funds often need to be moved into a new account specifically titled as an inherited IRA. This account must be titled to include the deceased owner’s name and indicate it is “for the benefit of” (FBO) the beneficiary, such as “John Doe (deceased) FBO Jane Doe, Beneficiary.” Correctly titling this account ensures it retains its tax-advantaged status and avoids unintended taxable distributions.

When ready to take distributions, submit a distribution request form to the financial institution. This form allows you to specify the amount to withdraw and your preferred method, such as direct deposit or check. While the institution does not typically advise on RMD calculations or 10-year rule adherence, you are responsible for ensuring withdrawals comply with the rules applicable to your beneficiary type.

You can elect to have federal and, if applicable, state income tax withheld from your distributions. This can help manage your tax liability and avoid a large tax bill. It is also advisable to name a new beneficiary for your inherited IRA, as rules for subsequent beneficiaries can differ. Maintaining thorough records of all communications, submitted forms, and distributions received is recommended for accurate financial tracking and tax reporting.