Properly dealing with an inherited IRA can be tricky business. If you take the right steps, you can continue to delay taxation on the account for many years. But if you make a mistake, the entire account balance could be taxable immediately — thereby wasting a potentially huge sum of money on taxes.
When you inherit an IRA, the rules that apply to you depend on whether or not the deceased account owner was your spouse. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.
Inherited IRA: Spouse Beneficiary
As a spouse beneficiary, you have two primary options:
- Do a spousal rollover — rolling the account into your own IRA, or
- Continue to own the account as a beneficiary.
Note: There’s no deadline on a spousal rollover. Should you want to, you can own the account as a beneficiary for several years, then elect to do a spousal rollover.
If you continue to own the account as a beneficiary, the rules will be mostly the same, with a few important exceptions.
No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59.5, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)
Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).
Spouse Beneficiary RMDs
Third, you’ll have to start taking required minimum distributions (RMDs) in the year in which the deceased account owner would have been required to take them. (If the original owner — your spouse — was required to take an RMD in the year in which he died, but he had not yet taken it, you’re required to take it for him, calculated in the same way it would be if he were still alive.)
Your RMD from the account will be calculated each year based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590.**
Inherited IRA: Non-Spouse Beneficiary
When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.
No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)
Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)
Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a Required Minimum Distribution from the account. (If the account owner was required to take an RMD in the year of his death but he had not yet taken one, you’ll be required to take his RMD for him, calculated in the same way it would be if he were still alive.)
The rules for calculating your RMD are similar (but not quite identical) to the rules for a spousal beneficiary. Again, your first RMD from the account will be calculated based on your own remaining life expectancy from the “Single Life” table in IRS Publication 590. However, in following years, instead of looking up your remaining life expectancy again (as a spousal beneficiary would), you simply subtract 1 year from whatever your life expectancy was last year.**
For example, imagine that your grandfather passed away in 2010 at age 65, leaving you his entire IRA. For 2010 (the year of death), you have no RMD. On your birthday in 2011, you turn 30 years old. According to the Single Life table, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2011 will be equal to the account balance as of 12/31/2010, divided by 53.3.
For 2012, your RMD will be equal to the account balance at the end of 2011, divided by 52.3. In 2013, it’ll be the end of 2012 balance, divided by 51.3.
Important exception: If you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.
Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.
Successor beneficiaries are subject to the same rules as the original beneficiary, with one exception: The successor beneficiary must continue to take distributions each year as if they were the original beneficiary.
By way of illustration, in the example above, if you had died in 2013, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2013 distribution, she’d have to take it. Her 2014 distribution would be exactly what yours would have been if you were still alive: the 12/31/2013 balance, divided by 50.3.
Tips for Non-Spouse Beneficiaries
- When you retitle the account, be sure to include both your name and the name of the original owner.
- Name new beneficiaries for the account ASAP.
- If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.
Inherited IRA: Multiple Beneficiaries
If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.
However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:
- A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
- Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.
To split an inherited IRA into separate inherited IRAs:
- Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
- Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
- Change the SSN on each account to be that of the applicable beneficiary.
A Few Last Words
When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes (attempting a rollover rather than a trustee-to-trustee transfer, for instance) can be very costly.
Also, should you elect to get help with the decision — a good idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.
**If a) the inherited IRA is a traditional IRA, b) you are older than the deceased IRA owner, and c) the deceased IRA owner had reached his “required beginning date” (i.e., April 1 of the calendar year following the calendar year in which he turns age 70.5) by the time he died, your RMD could actually be smaller than the amount calculated above, as you can calculate it based on what would be the deceased owner’s remaining life expectancy (from the “Single Life” table) using the owner’s age as of his birthday in the year of death (and reducing by one for each following year).