Lee Huffman and Paul Kim
Feb. 23, 2023
- An inherited IRA is an account an individual establishes with the funds bequeathed from a deceased person's IRA or 401(k).
- Inherited IRAs follow the same tax regulations as regular IRAs: You only owe taxes on the funds you withdraw.
- Spouses aside, most beneficiaries can't make contributions to an Inherited IRA and must empty the account over the course of 10 years.
If you're on the receiving end of an inheritance, odds are the money is coming to you out of the deceased's retirement account. And you may be asked — or sometimes told — to set up an inherited IRA.
Inherited IRAs (investment retirement accounts) are accounts a person sets up with the funds bequeathed to them after an IRA owner dies.
Basically, they're the same tax-deferred vehicles as regular IRAs. But how you, the beneficiary, handle them — well, "it's complicated," says Peter Riefstahl, a CPA and accountant at Yum! Brands. "The rules vary depending on your relationship to the deceased, at what age they died, and what type of beneficiary you are."
Understanding those rules is crucial to getting the most out of the inherited IRA — and avoiding running afoul of the IRS. Here's an overview of how they work.
What is an inherited IRA?
Also known as a beneficiary IRA, an inherited IRA is an account that holds the assets inherited from a decedent's tax-advantaged retirement plan. The money inherited continues to grow with the same tax conditions that applied to the original IRA.
Inherited IRAs can be funded from any type of IRA: including traditional, Roth, SIMPLE, and SEP IRAs. It can also be created out of money from the deceased's 401(k) plan. You can set an inherited IRA up with almost any bank or brokerage. But the easiest option may be to open your inherited IRA with the firm that held the deceased's account.
For tax purposes, it's important that the account be named properly — designated as inherited, and with both parties' names. Typically, the title reads something like: [Name of Recipient] Inherited IRA Beneficiary of [Deceased's name].
The person or entity that inherits the IRA can be anyone that the deceased person named as a beneficiary in the IRA paperwork. It's this designation that dictates who inherits the IRA — even if the deceased's will names somebody else.
What to do with an inherited IRA
Beneficiaries fall into two categories: designated (people, like a spouse, relative, or friend) and not-designated (trusts, estates, charities).
Spouses can set up an inherited IRA, but they don't necessarily have to. It's actually more advantageous to forgo the inherited IRA and treat the deceased's IRA as their own: putting it into their name, or rolling it over into another IRA they already have. This is a special privilege that only spouses possess.
In contrast, non-spouse beneficiaries — everybody else, basically — have to set up a separate inherited IRA.
Inherited IRA rules
While inherited IRA rules are many and varied, there are two big takeaways:
- You can't make additional contributions to them. You can manage inherited IRAs – change the investments, buy and sell different assets – but additional deposits are not allowed.
- You have to withdraw money from them. The timetable varies by beneficiary, but sooner or later, you have to empty an inherited IRA completely or take a heavy IRS penalty. This applies even to inherited Roth IRAs. Unlike the original account owner, the inheritor of a Roth IRA is required to take distributions from the account.
Spouses have the most flexibility around these rules. If they've just put the deceased's IRA in their name or rolled the money over into their own IRA, they just have to start taking out money when they turn 72 — the usual IRA rule of required minimum distributions (RMDs). Rolling an IRA also allows them to continue making deposits.
If a surviving spouse sets up a new inherited IRA, they take the same distributions the deceased did, or recalculate the amount based on their own life expectancy. If the original owner passed away before the age of 72, then the surviving spouse doesn't have to start taking distributions until the year the deceased would've turned 72.
For most other individuals, withdrawals from the inherited IRA have to be made annually for 10 years. The key point: The beneficiary has 10 years (to the end of the calendar year) following the original account owner's death to withdraw all assets from the inherited IRA.
For example, say Papa Joe passes away on September 1, 2023, bequeathing his IRA to his grown daughter Jane. Jane sets up an inherited IRA. Her deadline for emptying the IRA is December 31, 2033, and she must withdraw the necessary amount every year.
What happens if you don't withdraw funds from an inherited IRA?
The consequences of missing withdrawals can be harsh. The IRS charges a penalty of 50% of the funds you were supposed to take out. Depending on the size of the IRA that you inherit, this can be serious money.
In 2022, the IRS changed the 10-year rule. Previously, you could take out the money from an inherited IRA at your leisure, as long as you did so before the 10-year mark — so you had the option to take it all out in one year, if the tax benefits made sense for you. Under the new rule, most non-spouse beneficiaries must take RMDs every year.
There was confusion when this new rule was released. So if you did not take out annual RMDs in 2021 or 2022 when you were technically supposed to, the 50% penalty is waived.
Are inherited IRAs taxable?
The tax rules that applied to the original IRA also apply to the resulting inherited IRA. Just like an IRA that you've funded yourself, money within the account grows free of income tax.
IRAs that have taxable withdrawals, such as traditional IRAs and SEP IRAs, continue to be taxable when withdrawn from their inherited counterparts. Any amount withdrawn is taxed at your regular income tax rate. The key to minimizing your tax liability is to withdraw at amounts that won't shift your tax bracket.
Inherited Roth IRA distributions continue to be tax-free, just like any Roths, as long as the deceased's original account is at least five years old. If the account was less than five years old at the time of the original owner's death, any withdrawn contributions are still tax-free, but any earnings above that are taxable when you take them out.
The IRS does offer beneficiaries one break. Typically, if you're under age 59 ½, any withdrawals from a retirement account, such as a traditional IRA or a 401(k) will incur a 10% penalty. This penalty is waived for inherited IRAs.
Inherited IRAs can be confusing, it can be a good idea to get expert advice before withdrawing money from an account. The IRS provides a detailed list of rules about distributions from IRAs. The page answers commonly asked questions, includes recent developments that may affect IRA distrubitions, and has information about any upcoming changes to the rules.
You also may want to speak with a lawyer or financial advisor when you inherit an IRA. It's best to find someone who has experience specifically with inherited IRAs.
Should you use an inherited IRA?
Unless you're a spouse, when you inherit a retirement account, your usual best option is to transfer the money into an inherited IRA. Inherited IRAs continue to grow tax-deferred until withdrawals are made. Taxes on withdrawals are treated the same as the original IRA account.
Most beneficiaries must withdraw all funds from their inherited IRAs annually over 10 years. Spouses, on the other hand, can withdraw assets on any schedule they wish.
"One could simply defer taking withdrawals for the decade, let the account grow (ideally), and then take it all out in the end," Riefstahl says. "The important caveat is that this will push you into a far higher tax bracket, thereby cutting into those gains that have accumulated over the years."
The rules for inherited IRAs are complex, and the variations are many. Our rundown covers just the basics. So before making any moves, definitely consult with a tax or estates-law professional regarding your particular circumstances.
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