What Do I Do with An Inherited IRA?

Investopedia’s article, “What to Do With Your Inherited IRA,” looks at the differences between a traditional IRA and a Roth IRA, what it means when you inherit them and how to navigate both.

IRAs come in two flavors: pre-tax and post-tax. A pre-tax retirement account means the money that goes into the IRA has not yet been taxed. This is a traditional IRA, where you add money to the account and can deduct that money on your tax return. When you withdraw money for retirement, you’ll then pay tax on the money. However, a Roth IRA is a post-tax retirement account. You contribute after-tax money to the account, and when you take money out in retirement, it is tax free.

If the decedent is over the age of 70½, he was required to take minimum distributions (RMDs), which will be taxable. Anytime an RMD is missed or is not taken in full, the IRS will impose a 50% penalty on the amount not removed from the account. If you have inherited a Roth IRA and the RMDs haven’t started for the decedent, the IRS has already collected the tax on the money in the account. The money won’t be taxed again, when it is withdrawn.

If you are a spousal beneficiary, you have a few more options. If the decedent started the required minimum distributions, you have four options:

  1. Roll IRA into Your IRA. When this money becomes your IRA, you follow all the traditional rules: you can only remove this money penalty free after the age of 59½, and you must start your own RMDs after 70½. You’ll also have to name your own beneficiary.
  2. Transfer the Assets into an Inherited IRA in Your Name. Because RMDs have already started, you must continue taking them. The RMDs will be taken based on your life, using the single life expectancy table from the IRS. They’re taxed at your ordinary tax rate. There’s no 10% penalty for early withdrawal. However, if you have an inherited IRA, you can’t designate a primary beneficiary—you must name a successor beneficiary, because if the successor beneficiary inherits the IRA, he’ll have to continue taking RMDs based on your This typically results in RMDs being very high and leaves the successor with a large tax bill.
  3. Take a Lump-Sum Distribution. When you take all the money at once, you avoid the 10% penalty, if you’re under 59½. However, you must pay tax on that large distribution. Of the three choices, you’ll typically want to combine the first two options above, especially if you’re under the age of 59½.
  4. Open an Inherited IRA and Close Account Within Five Years. This lets the account continue to grow for five years. Then you can close it and withdraw all the money. You will pay tax on the amount of the withdrawal, but there’s no 10% penalty for early withdrawal.

The options for an inherited Roth IRA are not much different for a spouse. You still have the option of rolling the Roth IRA into your own IRA. This is perhaps one of the best options with Roth IRAs. You can also open an inherited IRA, but you’ll need to distribute the money from the account. You must start RMDs on the later of the date when the decedent would have turned 70½ or by December 31st of the year following the year of death. If you opt not to start RMDs or you forget, you’ll have to close the account within five years. The IRS usually doesn’t require RMDs from a Roth IRA. The final option is to just take all the money from the account, which lets you to take the money out tax and penalty free.

Non-Spousal Beneficiaries. If you’re a non-spouse beneficiary, you have more limited options. If the decedent began taking RMDs, you have a few options. First, you can continue taking RMDs. Because the RMDs have already started, you must continue taking them. Next, you could take a lump-sum distribution and withdraw all the money at once. You’ll avoid the 10% penalty if you are under 59½. However, you’ll still have to pay tax on the distribution.

If the decedent was over 70½ and was required to take RMDs, you have the same options as if they were under 70½, plus one additional option of moving the IRA to an inherited IRA and closing it with five years. You don’t have to take the money out in one lump sum but can spread it out over five years. At the end of the five years, the account must be closed. If you have a Roth IRA, you have all the same options as a traditional IRA for a non-spouse beneficiary.

There are a few reminders to note. First, distributions from a traditional IRA do count as income—these distributions can jump you into a higher tax bracket, which is a factor to consider. If the decedent died without taking an RMD, assuming she was 70½, you first need to remove the RMD. If you forget or delay too long, it can cause you to be subject to an expensive penalty.

Reference: Investopedia (November 22, 2018) “What to Do With Your Inherited IRA”

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