What to Do If You Inherit An IRA?
If a family member dies, and you inherit their IRA, there are special rules regarding mandatory distributions that you need to be aware of. Depending on your relationship with the person who passed away and their age, you may be required to take annual distributions from the IRA, regardless of your age. And if you fail to comply with the rules, you could be subject to a penalty from the IRS for 50% of the distribution amount.
Nobody likes penalties, so let’s make sure that doesn’t happen to you.
Spousal Beneficiary of Traditional IRA
If your spouse dies and you are the beneficiary, you have two options available to you. The first option is to roll the money over to your own IRA. As a surviving spouse, you can either retitle the IRA so you are listed as the owner instead of your spouse, or you can transfer the funds to a separate IRA that you already have. If you become the new owner of the IRA, all you have to do is take your own annual Required Minimum Distribution (RMD) when you reach 70 ½ and that’s it. It’s very simple and very easy.
But simple may not be your best option. If you are under age 59 ½ and you become the owner of the IRA, you won’t be able to access the funds until you reach 59 ½ unless you want to pay a 10% early-withdrawal penalty. If you plan to use the money now, you are better off turning this into a “Beneficiary IRA”. With a Beneficiary IRA, you must take annual distributions over your lifetime, beginning in the year the decedent would have reached age 70 ½. These lifetime distributions are subject to income tax; however, they are not subject to the 10% early-withdrawal if you take a distribution before reaching age 59 ½.
With that said, most tax pros suggest that people take advantage of the spousal rollover rules. Reason being? Because if the money becomes a spousal IRA rollover, the RMDs are calculated based on the age of the survivor, not the deceased spouse. This means that if you are younger than your deceased spouse, you only have to take RMDs when you reach age 70 ½ and your RMD amount is based on your age, not your deceased spouse. This is beneficial because the assets and earnings will continue to grow tax-deferred.
Non-Spousal Beneficiary of Traditional IRA
If you inherit an IRA from someone you were not married to, you are not able to treat the inherited funds as your own, meaning you are not able to combine the assets with any of your existing IRAs. Unless you disclaim (decline to inherit) all or part of the assets, you are required to open and transfer the assets to an Inherited IRA. The IRS generally requires non-spouse beneficiaries to start taking RMDs beginning the year after the year of death, and each year thereafter. However, a non-spouse beneficiary has a few options available to them with regards to taking distributions.
First, if the person who died was already taking distributions but died before taking the RMD for that year, then you will have to take the money out that they would have as an RMD.
If they already took their RMD for the year in which they passed, or the person wasn’t required to take an RMD the year they died, you won’t have to take a distribution from the IRA for that year. But you will have to start taking your RMD based on your age beginning in the year after the owner passed away.
Alternatively, a non-spouse beneficiary may elect taxable distributions of the full amount over a 5-year period, without incurring a 10% penalty for distributions received prior to age 59 ½. If you decide to do that, it doesn’t matter how much you take out in any one year. You could take out nothing for 4 years and take everything out in the 5th year. As long as all of the inherited IRA assets are distributed by the end of year 5, you will avoid any penalties.
Spousal Beneficiary of Roth IRA
The same options are available to a spouse who inherits a Roth IRA, except that Roth IRA distributions are tax-free if the Roth account is at least five years old. The surviving spouse can treat the inherited Roth IRA as his or her own, including rolling it into a new or existing Roth IRA. They may choose to take tax-free distributions over their lifetime, over 5 years or as a lump sum, as long as the account is over five years old.
Non-Spousal Beneficiary of Roth IRA
A non-spouse beneficiary of a Roth IRA has the same options discussed above for a spouse, except for treating the Roth IRA as your own. This option is not available to non-spouse beneficiaries. Keep in mind though that as a non-spouse beneficiary of a Roth IRA, you are subject to annual required minimum distributions. Failure to take the required distributions could subject you to the IRS 50% penalty.
If you inherit an IRA that probably means someone you cared about passed away. That in turn means you may not be in the mood to deal with the ins and outs of these kinds of decisions. On top of the details of Spousal and Inherited IRAs, there are the issues of selecting the right beneficiary and retitling the account correctly. Whatever your situation, Bouchey Financial Group can assist you with navigating the rules of inherited IRAs.