When you inherit an IRA, there are traps for the unwary if you aren’t careful. Before doing anything with the IRA, learn your options and consult with an attorney or financial advisor as soon as possible to make the right decisions.
General Tax Rules During Lifetime
IRAs are tax-advantaged savings plans, to set aside money for retirement. Contributions to traditional IRAs get a tax deduction when made; earnings in a traditional IRA generally are not taxed until distributed to you. When you reach age 70 1/2 you have to start taking distributions from a traditional IRA.
Roth IRAs are taxed differently, in that there is no tax deduction for contributions made. Like traditional IRAs, the earnings in a Roth IRA are not taxed. The advantage for a Roth IRA is that you do not have to start taking distributions at any point, and withdrawals (including all earnings and appreciation) are not taxed when you withdraw them later.
When an IRA owner dies, any amount remaining in the IRA must be paid to a beneficiary or beneficiaries. The beneficiary might be a surviving spouse or children/grandchildren outright, or it could be a payment to a trust for the benefit of a family member.
Spouse as beneficiary
If you inherit your spouse’s IRA, special tax advantages apply to that IRA. Unlike other inherited IRAs, as the surviving spouse you can treat the IRA as your own. That allows you either to put the IRA in your name or to roll it over into a new IRA. Since the IRS then treats the IRA as if it’s always been your own, you may be able to defer distributions longer. For example, if you’re not yet age 70 ½ you can wait until you reach that age before starting minimum withdrawals. If you’re over 70 ½ and were 10 or more years younger than your spouse, you can use a longer “joint-life expectancy table” to calculate withdrawals. That means lower minimum withdrawal amounts each year.
If you inherit a Roth IRA you do not need to take any distribution, unless you decide to do so. You can let the money accumulate tax-free until you withdraw it years later or pass it to your children.
If you decide to leave the IRA account in your spouse’s name, you will need to begin taking withdrawals when your spouse would have turned 70 ½; or if your spouse was older than that already, then starting a year after his or her death. The IRA will need to be fully withdrawn over the five years.
Non-spouse as beneficiary
For a child or grandchild (or other non-spouse) who inherits an IRA,the rules are somewhat different than described above for a spouse. Generally it is best to allow the IRA to be retitled as an “inherited IRA” and take your first distribution by December 31 of the calendar year following the year the decedent died. Then you can take minimum distributions over your lifetime and to pass what is left onto future generations. This is sometimes called the “stretch” option. The required minimum distributions are calculated based on your life expectancy, according to the IRS charts.
Too many people make the mistake of withdrawing the IRA soon after it is received. That can lead to a large tax bill (unless the IRA is a Roth, which can be withdrawn tax-free).
Trust as beneficiary
Sometimes an IRA names a trust as a beneficiary. Not all trusts can stretch out withdrawals, and it may be necessary to fully withdraw (and pay the extra taxes) over a five-year period. Stretching an IRA distributions may be an option for some types of trusts, if the trust is considered a “see-through” or conduit trust. If you have inherited an IRA in a trust, contact your attorney to advice about your options.
No Beneficiary – To The Estate
When the IRA did not have a beneficiary named, the estate will generally be the IRA beneficiary. That mean the IRA will need to be withdrawn within five years, and taxes paid. There may be options to bypass the estate and stretch the distributions. Again, consulting with a qualified lawyer or CPA could save a lot in taxes.
For large estates, there may be some income tax deduction available to the IRA beneficiary if estate taxes were paid on the IRA. However, this will not apply to most estates since estate taxes now apply to estates of over $5 million.