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What You Should Know About Inherited IRA

Inherited IRA

If you are the recipient of an inherited IRA, there are some special rules and considerations you should be aware of. Failure to follow these rules can result in unintended tax consequences that could cost you a big chunk of your inheritance. 

Spouse vs. Non-Spouse IRAs

There’s good news if you inherited an IRA from your spouse. If you’re the sole beneficiary of your spouse’s IRA, you can treat the IRA pretty much as if it’s your own account by designating yourself as the owner of the account. Or if you own a separate IRA, you can roll the inherited IRA over into your own account to simplify paperwork and decision-making. In this scenario, you can also continue making contributions and leave the money in the account to continue growing if you don’t need it right away until you reach 70½ years of age. 

Things can get a little bit more complicated if you inherit an IRA from someone other than your spouse or if you’re not the sole beneficiary of your spouse’s IRA. In this scenario, you’ll have to establish a new IRA in your name. Also, you won’t be able to make any additional contributions to this new IRA and generally, you must take the first distribution by the end of the year following the death of the decedent. 

Beneficiaries of inherited IRAs are sometimes tempted to simply cash out the account by taking a lump-sum distribution. However, this cash-out will be treated as taxable income and taxed at your marginal rate, not the decedent’s tax rate. The good news is that withdrawals made by beneficiaries from inherited IRAs before age 59½ are not subject to a 10 percent early withdrawal penalty.

Stretch Out IRA Distributions

One common strategy for recipients of non-spouse IRAs is to take withdrawals over the course of their life expectancy. This strategy is known as a “stretch” IRA because you’re stretching out distributions for as long as possible in order to avoid taxes and leave funds in the account for long-term growth.

The IRS offers worksheets and calculators to help you determine the amount of withdrawals you should take based on your life expectancy. 

The rules are a little bit different for Roth IRAs. If you are the beneficiary of a Roth IRA, you can withdraw contributions made to the account at any time with no tax consequences. Earnings can be withdrawn tax-free if the account had been open for at least five years when the decedent died. However, if the Roth IRA was less than five years old at the time of the decedent’s death, taxes will be assessed on earnings that are withdrawn.

Inherited IRAs and RMDs

The IRS requires traditional IRA holders to begin taking required minimum distributions (or RMDs) from their accounts when they reach age 70½. However, the RMD rules for beneficiaries of inherited IRAs are a little bit different. In a nutshell:

  • Sole beneficiary of spouse’s traditional IRA — The same RMD rules that apply to traditional IRA holders also apply to the inherited IRA.
  • Sole beneficiary of spouse’s Roth IRA — Like your spouse, you will not be required to take RMDs when you turn 70½ years old. 
  • Non-spouse beneficiary or non-sole spouse beneficiary of a traditional IRA — You generally must start taking RMDs by December 31 of the year of the decedent’s death. However, depending on whether the decedent had started taking distributions, you might have until December 31 of the fifth year after the decedent died to start taking RMDs.
  • Non-spouse beneficiary or non-sole spouse beneficiary of a Roth IRA — You can postpone distributions until the decedent would have turned 70½ years old, or until December 31 of the year following the year the decedent died, whichever is later.

Keep in mind that if don’t take RMDs from an inherited Roth IRA when you’re supposed to, you could be assessed a 50 percent tax on the withdrawal amount you should have taken.

The rules concerning inherited IRAs can get complex. Therefore, you should consult with your financial and tax advisors for guidance in your specific situation.

Please give us a call if you have more questions about inherited IRAs.

The commentary is limited to the dissemination of general information pertaining to Frontier Wealth Management, LLC’s (“Frontier”) investment advisory services. This information should not be used or construed as an offer to sell, a solicitation of an offer to buy or a recommendation for any security, market sector or investment strategy. There is no guarantee that the information supplied is accurate or complete. Frontier is not responsible for any errors or omissions, and provides no warranties with regards to the results obtained from the use of the information. Nothing in this document is intended to provide any legal, accounting or tax advice and Frontier does not provide such advice. This information is subject to change without notice and should not be construed as a recommendation or investment advice. You should consult an attorney, accountant or tax professional regarding your specific legal or tax situation.