When it comes to retirement, there are a lot of options out there - from a traditional 401(k) to a 403(b) and everything in between. And while a traditional retirement plan (or an employer-sponsored plan) may be fairly straightforward, how do you handle an inherited Individual Retirement Account (IRA)?
With all of the rollover and distribution rules, not to mention spouse and non-spouse IRAs, how do inherited IRAs work? And how can you get the most out of yours?
What is an Inherited IRA?
An inherited IRA, or "beneficiary IRA," is a retirement account that opens or is inherited at the time of the previous owner's death. There are both spouse and non-spouse inherited IRAs, but the plan is typically a traditional IRA or employer-sponsored retirement program. With this type of plan, the recipient of the inherited IRA is the beneficiary, and has several options for how to cash out or incorporate their inherited account into their retirement plan.
However, inherited IRAs - particularly if they are non-spouse plans - play by a different set of rules than other retirement plans, so knowing exactly how to navigate them is crucial to making the most of your IRA.
Non-Spouse Inherited IRA
If you've inherited an IRA from a non-spouse (for example, from another relative, trust, or estate), you have several different options for using (or cashing out) your IRA.
And while you cannot rollover your inherited IRA into your own IRA or make contributions, you can avoid the 10% penalty for early withdrawals while taking distributions - but, depending on your inherited IRA custodian, your options may be somewhat limited.
But before you make any decisions, you need to understand how your non-spouse inherited IRA works and what options you have.
Cash Out Immediately Option
One of your options with a non-spouse inherited IRA is to simply cash out right away.
As a non-spouse beneficiary, you have ability to simply withdraw 100% of the funds in the account immediately - which will all be included in your taxable income that year. For this reason, many people opt not to withdraw all of the funds from their inherited IRA immediately because of the steep income tax they would accrue.
By withdrawing all funds immediately, you will likely put yourself in a higher tax bracket, so you will need to ensure you have enough funds to pay the additional taxes while not spending too much of the account in one year.
However, if you do not do anything to your inherited IRA before Dec. 31 of the year following the death of the previous owner, you will be forced to cash out immediately - and take on the taxes that come with it.
The "Stretch Option"
What experts consider a goldmine, the so-called "stretch option,"or "stretch IRA," gives you the ability to take required minimum distributions (RMDs) over the course of your own lifetime based on life expectancy (see how to find your life expectancy for IRAs here) - and can save you big on taxes. By choosing the "stretch IRA" option, the majority of your inherited account will be able to grow tax-deferred (or, for Roth IRAs, tax free).
Taking out RMDs over the course of your life expectancy can be a very efficient option, especially for younger beneficiaries. In order to begin receiving distributions, you must create a separate inherited IRA account with the previous owner's name and name yourself beneficiary - then, you must take your first distribution before Dec. 31 of the year following the previous account owner's death. You will likely be able to name your own beneficiaries to the new account to be doled out in a similar manner.
When choosing the "stretch IRA" option, your distributions will be part of your taxable income each year. You will not be taxed on the account until you begin taking distributions. For more information, check out the Internal Revenue Service site.
Take Out RMDs
You may also be able to take out RMDs for the duration of the oldest beneficiary's life expectancy if there are multiple beneficiaries listed on the IRA. For this option, you will receive RMDs in a similar fashion as a "stretch IRA" by being taken as part of your yearly income tax.
However, if you do not take out distributions (even if you are using the "stretch option"), you can incur a 50% tax penalty on any funds below the RMD amount per year. The particular amount of your RMD will be determined by the IRS.
As a plus, even if you are under 59.5 years of age, the early-withdrawal tax of 10% is not applicable to inherited IRAs.
Cash Out after 5 years
If you can wait a little bit to liquidate your inherited IRA, choosing to cash out after 5 years may be a better option than doing so immediately.
As a non-spouse beneficiary, you can often opt to withdraw funds by Dec. 31 of the fifth year after the death of the previous owner of the account. However, because of the hefty tax on liquidating your IRA (especially if it is sizable) - which could mean upwards of 25% going to federal taxes - you might wish to opt for a RMD plan (if possible).
Spouse Inherited IRA
With a spouse inherited IRA, you as the beneficiary have several different options (and rules). According to the IRS, spouses generally have three main options when dealing with their inherited IRA: absorb or treat the inherited IRA as their own IRA, rollover the IRA into their own retirement account or treat themselves as a beneficiary instead of an owner of the IRA.
Unlike non-spouse inherited IRAs, spouses are given the option of transferring the IRA into their name and deferring distributions until your first RMD - in other words, you won't have to take RMDs immediately and can wait 60 days to decide to rollover your inherited IRA.
While you can still cash out the IRA immediately if you wish (which would come with hefty income taxes, just like a non-spouse inherited IRA), the extra bump into a higher tax bracket that year may not be worth it. And, with a spouse inherited IRA, you have several other benefits that you may want to take advantage of.
Roll Over Funds into Your Own IRA
One of the major benefits of having a spouse inherited IRA is that you can roll over the assets from the inherited IRA into your own account - although contributions still can't be made. Once you rollover the funds into your own IRA, you can consolidate all of your retirement accounts as well as use the assets when you need them. Within 60 days of receiving the IRA, you can opt to rollover the distributions as long as they are not required distributions, and can be very advantageous.
However, to make the most out of rolling over your inherited IRA, make sure that you are either younger than your spouse at the time of their death after 70.5 years of age (which would allow you to defer RMDs until after you are 70.5 years of age), or you are over 59.5 years of age (in order to avoid a 10% penalty on funds withdrawn early), according to Fidelity (FNF) .
For further details on the paperwork necessary for rolling over funds, see this Fidelity page.
Treat the Inherited IRA as Your Own
Just like the rollover option, you may also treat the inherited IRA as your own by either rolling over the assets into your own retirement account, or by naming yourself as the account owner to the IRA.
According to the IRS, you will be considered to have claimed the IRA as your own if you make contributions to the account or do not take any distributions the first year of receiving it. Additionally, the IRA will be considered your own if you are the sole beneficiary and have full withdrawal powers.
Treating the inherited IRA as your own is generally a better option if you are over 59.5 years of age, or if your spouse was over 70.5 years of age when they died. In this manner, when claiming the IRA as your own, you will be able to defer RMDs on your own life expectancy - in which case, you won't have to start taking RMDs until you are 70.5 years of age.
Still, if you are not yet 59.5 years of age when you inherit the IRA, you will be taxed a 10% penalty by treating it as your own.
Treat Yourself as the Beneficiary
Another option for spouse inherited IRAs is to treat yourself as the beneficiary of the IRA - not the owner.
This may be a better choice for spouses who are younger than 59.5 years of age, since your RMDs will be determined by your spouse's age at the time of their death. However, even if your spouse was already taking RMDs at the time of their death, you will be able to take distributions based on either your own life expectancy or your spouse's according to their previous schedule.
With treating yourself as the beneficiary, you are able to take penalty-free withdrawals before the age of 59.5, and if your spouse was younger than you and had not yet started taking their RMDs, you will be able to wait until they would qualify for RMDs instead of your own age of distributions (70.5 years of age).
Inherited IRA Distribution Rules
For spouse inherited IRAs
If your spouse died younger than 70.5 years of age, you may receive distributions either by treating the IRA as your own, rolling over the assets into your own IRA and using your life expectancy for RMDs, getting a lump sum distribution immediately or after five years. However, in most cases you will be able to count the RMD age rules under your spouse's age (for example, when they would have turned 70.5 years of age as opposed to when you would).
If your spouse was older than 70.5 years of age at the time of their passing, you may receive distributions by the same methods, but will be penalized for withdrawing before the age of 59.5 (a 10% penalty tax), and must begin receiving RMDs as per your own life expectancy.
For non-spouse inherited IRAs
If you are receiving an inherited IRA not from a spouse, you will not be able to rollover the funds into your own account. Instead, you will have until Dec. 31 of the year following the previous account owner's death to either take out a lump sum immediately (taking on a full income tax for the funds), wait five years to withdraw the funds in total, or begin taking RMDs.
In most cases, distributions will begin a year after the account holder's death by Dec. 31 - which will be taxed by each distribution. Still, you will not incur a 10% penalty fee.
Inherited IRA Rollover Rules
With an inherited IRA, you have the option of rolling the inherited account into another account - like a traditional IRA, 403(b) or 457(b) plan - if you are the spouse of the previous account holder.
However, you must opt to roll over the funds into a new account within 60 days of receiving the inherited IRA.
Rules for Inherited Roth IRAs
The rules for inherited Roth IRAs are very similar to traditional IRAs - except contributions are made post-tax, so withdrawing funds is tax-free to beneficiaries (as long as the previous account holder had the IRA for at least five years).
Withdrawing from an inherited Roth IRA is similar to a traditional inherited IRA, in that you can either liquidate the account and withdraw all the funds immediately (and with a Roth, you won't be taxed on the funds), or take distributions which must begin by Dec.31 of the year after the original holder died.
Withdrawing from your Inherited IRA
Experts recommend that, instead of asking your IRA custodian for advice on withdrawing from your IRA, you should consult the services of a financial adviser or estate planning attorney to seek the best option for you.