How to Handle an Inherited IRA: Rules and Tax Regulations

FT Contributor  | 

If you recently lost a loved one, you may find it hard to focus on finances and making smart decisions for your future. At such a stressful time, the confusion that comes from dealing with an inherited individual retirement account (IRA) may be overwhelming. However, it’s important to learn the best choices you can make when this windfall occurs.

If you make a mistake during the inheritance process, such as not titling the new account properly or forgetting to take the required minimum distribution, it could cost you. The Internal Revenue Service (IRS) has several tax laws related to inherited IRAs and if you don’t transfer the account correctly, the department won’t offer you a second chance.

Learning how these tax laws behave and what your best moves are to receive your inherited IRA money unscatched is crucial. Find out more about inherited IRA rules so you can make the most of your inherited money.

Rules for Spouse and Non-Spouse Beneficiaries

Whether you’re a spouse or a non-spouse, you must complete certain forms so you’re eligible to receive distributions. The forms you’re responsible for completing depend on how you decide to treat the inherited IRA. In most cases, you can choose between an IRA with a five year rule or a stretch IRA.

With a five-year-rule IRA, you transfer the inherited IRA into your name and the money is available for distribution up to the end of the fifth year after the account holder passed away. After December 31 of the fifth year, no more distributions can be taken, even if you accidentally left money in the account.

While you won’t have to pay a 10% early withdrawal penalty, you do owe income taxes on each distribution you take. You can also set your own beneficiary and the money you leave in throughout the five years continues to grow. To complete this process, you must fill out a form with your financial advisor to create a new inherited IRA in your name. Your advisor may also ask for the original account holder’s death certificate.

If your loved one had a stretch IRA and you’re the beneficiary, the account may have been passed down generations. This allows the money in the account to continue growing over time. You must take minimum distributions each year from this inherited IRA based on your life expectancy. The amount you must distribute is determined by IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs).

No matter what age you are when you inherit the IRA, you must begin taking annual minimum distributions from it once it’s in your name. Before you decide how to take distributions, review your tax liability with each schedule.

When a Spouse Inherits an IRA

If you inherit an IRA from a spouse who passed away, the rules are more lenient. You can basically treat the IRA as your own and decide if you want to begin taking out distributions or transfer the IRA to a new institution. When comparing different financial institutions to manage your inherited IRA with, consider the following:

  • Does the advisor understand your entire financial picture?
  • Are you on the same page with your retirement plan?
  • What fees does the financial advisor charge?
  • When are you responsible for paying these fees?
  • Does the institution have good past customer reviews?

If you have an existing IRA, you can choose to transfer the funds from the inherited IRA into your own account.

Options for Non-Spouse Beneficiaries

As a non-spousal beneficiary, the rules are more strict. You can choose between the five-year-rule, life expectancy method, or lump sum distribution. If the account holder died after December 1, 2019, the Secure Act applies to your inherited IRA. With this law, you must complete all distributions within 10 years of the death date or you forfeit what’s left in the IRA.

The IRS doesn’t allow you to simply roll over the money in the inherited IRA into your own IRA. If you want the money to continue growing without taking distributions, you must set up a new IRA that’s titled as an inherited IRA. You can’t make contributions to this new IRA.

Tax Rules When Withdrawing From an Inherited IRA

When you inherit an IRA and begin taking out withdrawals, you must follow specific IRS guidelines to minimize your tax liability. Depending on the IRA and how you plan to receive distributions, you may need to withdraw a minimum amount each year. If you don’t, you’re charged a 50% penalty on the money that wasn’t withdrawn. You can take out more than the minimum distribution but you’ll owe taxes on this distribution amount.

It’s also important to keep expiration dates in mind. If you used the five year method, you must have all funds withdrawn after five years. With any other method, you have 10 years to empty the account or you lose what’s left.

How to Avoid Early Withdrawal Penalties

With an inherited IRA, you don’t have to worry about early withdrawal penalties as you would with your own IRA. However, you are responsible for paying taxes on the money you receive in distributions. In most cases, this money is treated as income. You must pay federal taxes and depending on where you live, you may owe state income taxes on these distributions as well.

Tips for Handling an Inheritance

When you’re handling an inheritance, it’s important to understand the taxes and fees associated with the money, such as an estate tax or income taxes on withdrawals. When handling your inherited IRA, be sure you:

  • Choose the best method for distribution;
  • Understand the deadlines for distribution;
  • Review your required minimum distribution;
  • Seek assistance from a financial advisor if transferring the IRA;
  • Focus on minimizing your tax liability.

When you inherit an IRA, reviewing your options and choosing the most financially beneficial distribution method is crucial. When you minimize your tax liability, you maximize your distribution.


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