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What You Should Know About Inherited IRAs

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, accounting, investment or other professional advice. You should confirm any information with a tax professional.

Inheriting an IRA or Roth account can be a significant financial event with far-reaching implications for your future. Whether you've recently become a beneficiary of a loved one's retirement account or you're proactively planning for the possibility of inheritance, understanding the intricacies of managing an inherited IRA or Roth account is crucial. From navigating the tax implications to exploring distribution options and making informed decisions aligned with your financial goals, this article aims to provide a comprehensive guide to what you need to know about inheriting an IRA or Roth account.

What is an IRA?

An Individual Retirement Account (IRA) is a special savings account designed to help people in the United States save money for retirement. With an IRA, individuals can put aside a portion of their income each year and invest it in a variety of ways, such as stocks, bonds, or mutual funds. The money in an IRA grows over time, and depending on the type of IRA, it may offer tax benefits, like tax deductions on contributions or tax-free withdrawals in retirement. IRAs are a way for people to take control of their retirement savings and build a nest egg for their future.

What is the difference between an IRA and a Roth account?

The primary difference between a Traditional IRA and a Roth IRA lies in how they are taxed. In a Traditional IRA, contributions may be tax-deductible, meaning you can deduct the amount you contribute from your taxable income in the year you make the contribution. However, when you withdraw money from a Traditional IRA in retirement, those withdrawals are taxed as ordinary income. On the other hand, contributions to a Roth IRA are made with after-tax dollars, so you don't get a tax deduction for your contributions. However, qualified withdrawals from a Roth IRA, including both contributions and earnings, are tax-free in retirement. Additionally, Roth IRAs offer more flexibility for withdrawals, as you can withdraw your contributions (but not earnings) at any time without penalty. Overall, the choice between a Traditional IRA and a Roth IRA depends on your current and future tax situation and your personal financial goals.

What does it mean to inherit an IRA or Roth?

Inheriting an IRA occurs when an individual receives an IRA (Individual Retirement Account) from someone who has passed away. When this happens, the inheritor typically becomes the beneficiary of the IRA and gains control over the assets within the account. Depending on the specific circumstances, such as the relationship to the original account holder and the type of IRA, the inheritor may have various options regarding how to manage the inherited IRA. These options could include taking distributions over their own life expectancy, using the "10-year rule" for non-spouse beneficiaries introduced by the Setting Every Community Up for Retirement Enhancement (SECURE) Act, or even taking a lump-sum distribution. Each option comes with its own tax implications and considerations, so it's essential for the inheritor to understand their choices and consult with financial and tax professionals to make informed decisions based on their individual circumstances and financial goals.

Inherited IRA options and rules

The IRS has specific IRA inheritance rules that you’ll need to check and follow to ensure you don’t encounter any tax penalties when managing your IRA. The rules you follow will depend on when you inherited the Roth or IRA account and what your relationship to the original IRA holder was. For example, the inheritance of an IRA by a spouse will have different rules than an inherited IRA split between siblings.

What does Required Minimum Distribution (RMD) mean?

Required Minimum Distribution (RMD) refers to the minimum amount that individuals with certain types of retirement accounts, such as Traditional IRAs or employer-sponsored retirement plans like 401(k)s, must withdraw from their accounts each year once they reach a certain age. The purpose of RMDs is to ensure that retirees do not indefinitely defer paying taxes on their retirement savings. It's essential for individuals with retirement accounts subject to RMDs to understand and adhere to these requirements to avoid potential tax penalties and ensure they are managing their retirement savings appropriately.

What are Required Minimum Distributions (RMD) for inherited IRAs?

Required Minimum Distributions (RMDs) rules for inherited IRAs differ from those for traditional IRAs owned by the original account holder. When an individual inherits an IRA, whether from a spouse or someone else, they become subject to specific inherited IRA RMD rules:

For non-spouse beneficiaries:

1. Traditional IRAs: Non-spouse beneficiaries typically must begin taking RMDs from the inherited IRA by December 31 of the year following the original owner's death. The distribution schedule is based on the beneficiary's life expectancy, as determined by IRS tables. These distributions are taxable as ordinary income.

2. Roth IRAs: Non-spouse beneficiaries of Roth IRAs are also required to take RMDs, but these distributions are generally tax-free because Roth IRAs are funded with after-tax dollars. The distribution schedule for Roth IRAs is also based on the beneficiary's life expectancy.

The rules for inherited IRAs can be complex and vary depending on factors such as the relationship to the original account owner, whether the account owner died before or after the required beginning date for RMDs, and whether the beneficiary chooses to stretch distributions over their own life expectancy or over a shorter period.

Failure to take RMDs from an inherited IRA as required can result in significant tax penalties, so beneficiaries should ensure they understand their obligations and consult with a financial advisor or tax professional if needed.

How can I calculate what my RMD should be?

Luckily, many larger financial institutions provide an inherited IRA RMD Calculator specifically for this purpose. Using one of these inherited IRA Distribution Calculators can help you figure out your RMD without having to run the numbers yourself. If you don’t want to identify your RMD by using an inherited IRA Calculator from a financial institution, you can also visit the IRS’s website to fill out one of their Required Minimum Distribution Worksheets.

What is the 10 year rule for inherited IRAs?

The "10-year rule" for inherited IRAs is a provision introduced as part of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was signed into law in December 2019. This rule applies to most non-spouse beneficiaries who inherit IRAs (including both Traditional and Roth IRAs) from account owners who passed away on or after January 1, 2020.

Under the 10-year rule:

1. Non-spouse beneficiaries are generally required to withdraw all funds from the inherited IRA by the end of the 10th calendar year following the year of the original account owner's death.

2. Unlike the previous rules, there are no annual Required Minimum Distributions (RMDs) mandated during the 10-year period. Instead, beneficiaries have flexibility in how and when they withdraw funds as long as the account is depleted by the end of the 10-year period.

3. Beneficiaries can choose to withdraw funds in any amount and at any time within the 10-year window, whether in periodic distributions, lump sums, or at the end of the 10-year period.

4. The 10-year rule does not apply to certain eligible designated beneficiaries, such as surviving spouses, minor children (until they reach the age of majority), disabled or chronically ill individuals, and beneficiaries who are not more than ten years younger than the original account owner.

While the 10-year rule provides flexibility in distribution timing within the specified period, beneficiaries should carefully consider the tax implications of withdrawals and plan accordingly to minimize their tax burden. Additionally, consulting with a financial advisor or tax professional is recommended to navigate the complexities of inherited IRAs and ensure compliance with relevant regulations.

I inherited an IRA; what do I do?

Inheriting an IRA comes with various options and considerations, depending on your relationship to the original account owner, the type of IRA (Traditional or Roth), and when the account owner passed away. It also comes with its own set of inherited ROTH/IRA distribution rules that you’ll need to follow to make sure you avoid any tax penalties. Here are some steps to consider after inheriting an IRA:

1. Understand the type of IRA you inherited: Determine whether the inherited IRA is a Traditional IRA or a Roth IRA. The rules and tax implications can vary significantly between the two types of accounts.

2. Review the beneficiary designation form: Check the beneficiary designation form provided by the IRA custodian or trustee to confirm your inheritance status and any specific instructions or restrictions.

3. Understand your distribution options: Familiarize yourself with the distribution options available to you based on your relationship to the original account owner and the date of their passing. If the original account owner passed away before January 1, 2020, you may have different distribution options compared to those inheriting after that date.

4. Consult with a financial advisor or tax professional: Given the complexities of inherited IRAs and the potential tax implications, it's advisable to seek guidance from a financial advisor or tax professional who can help you understand your options and make informed decisions based on your financial goals and circumstances.

5. Consider your distribution strategy: Depending on the type of IRA and your financial situation, you may have the option to take distributions over your life expectancy, use the 10-year rule (if applicable), or take a lump-sum distribution. Each option has different tax implications and considerations, so it's essential to evaluate them carefully.

6. Stay informed about tax laws and regulations: Tax laws and regulations related to inherited IRAs can change over time. Stay informed about any updates or changes that may affect your inherited IRA and consult with professionals as needed to ensure compliance and optimize your financial strategy.

Remember that inherited IRAs can be complex, and the decisions you make can have significant financial implications. Taking the time to understand your options and seeking professional guidance can help you make informed decisions that align with your financial goals and objectives.

If you’ve recently lost a loved one and are feeling overwhelmed with managing the logistics, or just want some sort of guidance through it all, check out Ever Loved’s free post-death checklist that covers everything you need to know about after someone dies. The checklist is free and easy to use, lets you invite others to help you in completing the list, and provides information on all steps you’ll need to take.

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