What happens if I inherit an IRA?

January 24, 2020, by John Norris

A lot people have an IRA or some other form of tax-deferred retirement account. As the owner doesn’t deplete the account(s) prior to their death, someone else will have to deal with the IRS’s rules regarding inherited IRAs.

For the surviving spouse, the rules are pretty straight forward. According to the irs.gov, you have the following options:

  1. Treat it as your own IRA by designating yourself as the account owner.
  2. Treat it as your own by rolling it over into your IRA, or to the extent it is taxable, into a:
    1. Qualified employer plan,
    2. Qualified employee annuity plan (section 403(a) plan),
    3. Tax-sheltered annuity plan (section 403(b) plan),
    4. Deferred compensation plan of a state or local government (section 457 plan), or
  3. Treat yourself as the beneficiary rather than treating the IRA as your own.

Often, but not always, it makes sense for the surviving spouse to simply treat it as their own, assuming they are the sole beneficiary of the IRA and there are no superseding restrictions on normal withdrawals. As a result, we almost always see spouses choose option #1 or #2, ordinarily #1. They simply have to adhere to the same rules which would apply to IRAs already in their name.

However, if you are the spouse or if the spouse decides to treat themselves as a beneficiary, the rules are a little different. Much depends on whether the deceased had to take a Required Minimum Distribution (RMD) after turning 70.5 years.

If NOT, the IRS outlines 3 primary options, which schwab.com describes far better as:

  1. Open an Inherited IRA using the ‘life expectancy method.’
    1. Transfer assets into an inherited IRA in your name
    2. Distributions must begin no later than 12/31 the year after the account holder’s death
      1. Annual distributions are determined by using either Table 1 (Single Life Expectancy) or Table 2 (Joint Life and Last Survivor Expectancy)
      2. RMDs are mandatory
      3. There is no early withdrawal penalty
      4. Undistributed assets continue to growth tax-deferred
  2. Open an Inherited IRA using the ‘5 Year Method.’
    1. Transfer assets into an inherited IRA in your name
    2. Money is available at any point up until 12/31 of the fifth year after the account holder’s death. All assets MUST be fully distributed at/by this time.
      1. Each distribution is taxed at your marginal rate
      2. There is no early withdrawal penalty
      3. Undistributed assets continue to grow tax-deferred until the mandatory payout
  3. Take a lump sum distribution
    1. All assets are distributed to you
    2. Money is immediately available
      1. You will pay income taxes on the entire distribution at once
      2. There is no early withdrawal penalty

If the account holder was OVER 70.5 years and subject to an RMD, the beneficiary of the IRA can either: 1) open an Inherited IRA using the ‘life expectancy method,’ or; 2) take a lump sum distribution. The only difference here is the beneficiary is NOT able to use the 5 Year Method.

The official language on inherited IRAs can be found at:

https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary

and

https://www.irs.gov/publications/p590b#en_US_2018_publink1000231238