A Complicated Inheritance: IRAs

Inheriting an individual retirement account (IRA) can be complicated and particularly stressful if you’ve just lost a loved one. Having an idea of what you need to do can help avoid the potential missteps associated with an IRA inheritance.

If you inherit a traditional IRA, you also inherit the income taxes that will be due when money is withdrawn from the account. Your tax liability could be significant if you withdraw all the money right away; some other options can help offset that tax hit and may be financially beneficial.

There are very different rules depending on whether you inherit an IRA as a spouse or non-spouse.

Spousal Inheritance

If you are the sole designated beneficiary of your spouse’s IRA, you have the option to leave the account as-is and designate yourself as the account owner—or you can roll the funds over into your own traditional IRA.

Either way, you won’t have to take any money from your IRA until after you reach age 70½. At that point, the tax law requires annual withdrawals of minimum amounts (called “required minimum distributions”). As long as you meet the required minimum; however, you’ll have the flexibility to leave money in the IRA if you want to—allowing the balance to continue growing tax-deferred.

A surviving spouse who decides to be treated as the IRA beneficiary can wait to start withdrawing funds until December 31st of the year the account owner would have reached age 70½. But you don’t have to: If you think you’ll have to take withdrawals before you reach age 59½, you may want to keep yourself as a beneficiary instead of the account owner so you can take withdrawals early without tax penalties.

As an account owner, any distributions you take before age 59½ could be subject to a 10% penalty in addition to income taxes.

Non-Spousal Inheritance

A non-spouse designated beneficiary can also stretch out withdrawals—and the related taxes—by setting up an inherited IRA. If handled carefully, inherited IRAs can be distributed throughout your life expectancy. Soon after the inheritance, you will have to begin taking minimum withdrawals, which are calculated using an IRS life expectancy table. The deadline for the first withdrawal is December 31 of the year after the account owner died.

Now What?

Inherited IRAs come with some complicated rules—and different rules may apply if an IRA passes through an estate instead of directly to a designated beneficiary. Because the penalties for insufficient withdrawals can be steep, it’s important that you be aware of the complexities and work closely with an advisor to choose the right course of action for your situation.