Receiving an inheritance is never good under any circumstances. Inherited IRAs come at a tough time so it's key to avoid adding additional pressure and stress to the situation by making a wrong move which can cost you in taxes and penalties.
Let’s talk about the differences between a traditional IRA and a Roth IRA, what it means when you inherit them and how to navigate both.
Traditional Versus Roth IRA
Individual retirement accounts come in two main categories. Pre and post-tax. A pre-tax retirement account means the money that goes into the IRA has not been taxed yet. This is a traditional IRA - you contribute money to the account and can deduct that money on your tax return. Later, when you decide to take money out for retirement, you will pay tax on the money at that time.
A Roth IRA, on the other hand, is a post-tax retirement account. You contribute after-tax money to the account. The good part here is when you take money out in retirement, it is tax free.
Required Minimum Distributions
Did the decedent start required minimum distributions in their IRAs? Traditional IRAs are great for kicking the tax can down the road, but eventually, the tax man (IRS) wants their money. If the decedent is over the age of 70.5, they are required to take minimum distributions. These distributions will be taxable. Anytime a required minimum distribution is missed or is not taken in full, the IRS will levy a 50% penalty on the amount not removed from the account.
If you have inherited a Roth IRA, required minimum distributions will not have started for the decedent. The IRS already collected their tax on the money in the account, and the money won’t be taxed again when it is withdrawn, so the IRS is not interested in requiring minimum distributions for these accounts.
If You Are a Spousal Beneficiary
Were you married to the person that passed on the IRA to you? If you were, you are a spousal beneficiary and have a few more options available to you. If you are a spousal beneficiary and the decedent started required minimum distributions, you have four options:
1. Roll IRA into Yours
This has the same effect as having your own IRA. It doesn’t matter if this is your first traditional IRA, or you already an established IRA to which you are adding. Once this money becomes your IRA, you must follow all the traditional rules. First, you can only remove this money penalty free, after the age of 59.5. Next, you must start your own required minimum distributions after the age of 70.5. Finally, you will have to designate your own IRA beneficiary.
2. Transfer Assets into Inherited IRA in Your Name
Your second option is to have the assets transferred into an inherited IRA in your name. Since required minimum distributions have already started, you must continue taking the required minimum distributions. It does not matter if you are over the age of 70.5. The distributions will be taken based on your life, using the single life expectancy table from the IRS. The required minimum distributions will be taxed at your ordinary tax rate.
If you take this route, you will not incur any 10% penalties for early withdrawal. There is another downside to taking this route. If you have an inherited IRA, you cannot name a primary beneficiary. You must name a successor beneficiary. The difference here is that if the successor beneficiary inherits the IRA, they will have to continue taking required minimum distributions based on your life. This typically causes required minimum distributions to be extremely high and hits the successor with a large tax bill.
3. Lump-Sum Distribution
Just as it sounds, this is taking all the money at once. You avoid the 10% penalty if you are under 59.5, but you must pay tax on that large distribution. Out of the three options, typically you will want to combine options one and two above. This is especially true if you are under the age of 59.5.
We recommend a combination because the IRA can be split into each option. If you will need a little money after the passing, keep that money in the inherited IRA. Move the rest of the money into your IRA. What happens if your spouse hadn’t started taking their required minimum distributions? In this case, you are given the same options as before, plus one additional option.
4. Open an Inherited IRA and Close Account Within Five Years
This additional option allows the account to continue to grow for five years and then you can close the account and withdraw all the money. The only downside here is that you will have to pay tax on the amount of the withdrawal. There will be no 10% penalty for early withdrawal.
The options for an inherited Roth IRA are not that different for a spouse. First, you still have the option to roll the Roth IRA in your own IRA. With Roth IRAs, this is probably one of the best options.
Second, you can open an inherited IRA. The issue here is that you will need to distribute the money from the account. You must start required minimum distributions on the later of the date when the decedent would have turned 70.5 or by December 31st of the year following the year of death.
If you choose not to start required minimum distributions, or you forget, you will have to close the account within five years. Normally, the IRS does not require minimum distributions from a Roth IRA, but they don’t want these accounts to sit around forever moving from one person to the next.
Your last option is to just take all the money from the account. This will allow you to take the money out tax and penalty free.
If You Are a Non-Spousal Beneficiary
When you are a non-spouse beneficiary your options are more limited. A non-spouse can be everything from a friend, family member, an estate or another non-human.
If you are a non-spouse beneficiary, and the decedent started required minimum distributions, you have three choices:
1. Continue Taking Required Minimum Distributions
Since required minimum distributions have already started, you must continue taking them. It does not matter if you are over the age of 70.5.
2. Lump-Sum Distribution
Your second option is to take a lump-sum distribution. Just as it sounds, this is withdrawing all the money at once. You will avoid the 10% penalty if you are under 59.5 but you will have to pay tax on the distribution.
Being a non-spousal beneficiary does not leave you with a lot of options. If the decedent was over the age of 70.5 and required to take minimum distributions, you have the same options as if they were under 70.5, plus one additional option:
3. Move IRA to an Inherited IRA and Close Account in Five Years
This additional option is to move the IRA to an inherited IRA and close the account out within five years. You do not have to take the money out in one lump sum. It can be taken out over five years. At the end of the five years, the account needs to be closed.
If you are dealing with a Roth IRA, you will have all the same options as a traditional IRA for a non-spouse beneficiary.
There are several nuances of which you need to be aware. First, remember distributions from a traditional IRA do count as income. However, that also means these distributions can knock you into a higher tax bracket, an additional factor you should be aware of and consider.
Second, you don’t need to be in a hurry to decide if you want to keep the IRA as an inherited IRA or if you should roll it into you own IRA. The IRS gives you until December 31 after the year of death to decide if you want to keep the inherited IRA or roll it into your own.
Third, if the decedent died without taking a required minimum distribution, assuming they are over 70.5, you first need to remove the required minimum distribution. Forgetting or waiting too long can cause you to be subject to penalty.
Inherited IRAs can be extremely complicated, especially in a tough situation. If you are not sure what to do at the proper moment, it can severely limit your options or subject you to penalties. The positive is that the only real time limit is taking care of the required minimum distribution. You can wait to make the decision on rolling the money over or keeping it as an inherited IRA.