Retired folks are often the recipients of Roth or traditional IRAs from a spouse or parent. While inheriting such funds from a loved one is a good thing, you must still do your due diligence to ensure you’re aware of the rules and regulations and don’t get hit with unnecessary taxes. For that reason I thought it would be helpful to outline some of the important things you should do when you inherit IRAs.
- Make sure you are listed as a beneficiary.
If a loved one leaves an IRA to you in a will, but you aren’t listed as the primary beneficiary, then you haven’t actually inherited the IRA. Make sure to check both documents before making assumptions.
- If no beneficiary is named, the financial firm supervising the IRA will choose one according to its own rules and/or IRS guidelines.
It may decide that the decedent’s estate will be the beneficiary of the IRA, which unfortunately is often the poorest outcome in terms of taxes owed.
- Be aware of your options as a spousal heir. Here are a few:
- You can “disclaim” all or some of the inherited assets. If you don’t want or need the money from an Inherited IRA, here is another option. By doing this, the disclaimed inheritance can go to the contingent (or successor) beneficiary named on the beneficiary form. Spousal IRA heirs sometimes do this with the goal of reducing income and estate taxes.
- You can create an inherited IRA to house the assets, and then roll over the assets from the inherited IRA into a new Roth IRA in your name. You will pay taxes on the Roth conversion, but the upside is the assets will go into a Roth IRA, paving the way for no RMDs, potentially lifelong contributions and tax-free withdrawals.
- You can transfer the assets into a new Inherited IRA in your name. If your spouse was older than 70½ when he or she died, then you must start taking RMDs from the Inherited IRA by December 31 of the year after the year of your spouse's death (or pay penalties to the IRS). If your spouse passed before age 70½, you might be able to postpone RMDs until the date when your spouse would have turned 70½.
- You can have the assets rolled over into your own IRA. This way, you can withdraw those inherited assets based upon your own life expectancy. If you transfer the inherited assets into a traditional IRA you already own, you don’t have to take Required Minimum Distributions from those assets until age 70½. If you transfer the inherited assets into a Roth IRA you already own, you don’t have to take RMDs from those assets at all. (Inherited Roth IRA assets can only be rolled over into Roth IRAs; inherited traditional IRA assets can only be rolled over into traditional IRAs.) Only spouses have this rollover option.
- Non-Spousal heirs also have choices.
Non-spousal heirs can either take lump-sum withdrawals or Required Minimum Distributions (RMDs) from an inherited IRA.
- Usually, your poorest option (tax-wise) is a lump-sum withdrawal. If you access the money at any point – that is, if the IRA custodian cuts you a check for the Inherited IRA assets and you deposit it in a bank account or IRA you have – that is not a direct rollover. That is an indirect rollover, and the entire amount withdrawn is treated as taxable income by the IRS. (An exception: if you cash out an Inherited Roth IRA, it is not a taxable event if the Roth IRA has existed for five or more years.) A direct rollover – in which only the custodian brokerages touch the money as they transfer it from one IRA to another – is not a taxable event.
- Taking RMDs is usually the better option. A beneficiary can arrange RMDs from an Inherited IRA, with a few different variations. Check with a financial professional about your particular situation as the rules can get complex.
- Non-spousal heirs cannot contribute to an Inherited IRA.
Spousal heirs who elect not to treat an Inherited IRA as their own or roll it over to their own retirement account also lose the ability to contribute to an Inherited IRA.
- You may be eligible for a tax deduction related to Inherited IRA income distribution(s).
Income from an Inherited IRA is what the IRS terms “income in respect of a decedent.” This means you can take an income tax deduction for the portion of the estate tax attributable to the Inherited IRA.
- If multiple beneficiaries are inheriting the IRA, you may be able to split the IRA up.
Some IRA custodians allow division of Inherited IRA assets among multiple beneficiaries.
Bottom line: If you inherit an IRA, study the rules. The more informed you are and the more guidance you have, the better the potential outcome. Also, please note this article is simply an overview, so be sure to also consult with a financial professional who is knowledgeable about IRA rules and regulations.