When an IRA or 401(k) account holder passes away, they might choose to leave their account to a loved one. But whether the recipient is surprised or knew about the inheritance ahead of time, they may have questions about what to do with this inherited IRA.
The key to properly handling an inherited IRA is to understand what it means for you as a beneficiary. Your relationship with the deceased, for example, could impact the tax consequences on the inheritance. But having an inherited IRA on your hands can also be a tremendous financial opportunity. Here’s what you should know moving forward if you’re the beneficiary of an IRA.
What is An Inherited IRA?
An inherited IRA, also called a beneficiary IRA, is a type of account you open to hold the funds passed down to you from a deceased person’s IRA. The original retirement account could have been any IRA, such as a Roth, traditional IRA, SEP IRA, or SIMPLE IRA. The deceased’s 401(k) plan can also be used to fund an inherited IRA.
Spouses won’t necessarily need to open an inherited IRA, because spouses are allowed to transfer any inherited assets directly into their own retirement accounts. However, any other beneficiary of the deceased’s account will need to open an inherited IRA, whether or not they already have a retirement account.
Some people prefer to open their inherited IRA account with the same firm that initially held the money for the deceased. It can make it simpler for the beneficiary while planning after the loved one’s passing. However, you can set up your account with almost any bank or brokerage.
Recommended: What is an Inherited 401(k)?
How Does an Inherited IRA Work?
When it comes to IRAs, there are two types of beneficiaries: designated and non-designated. Designated includes people, such as a spouse or friend. Non-designated beneficiaries are entities like estates, charities, and trusts.
This article focuses on designated beneficiaries. While your relationship with the deceased may impact your options and any rules surrounding your inherited IRA account, as can the age of the deceased at the time of death, certain rules apply to everyone:
1. You cannot make additional contributions to the inherited IRA. You can only make changes to the investments or buy and sell assets held by the IRA.
2. You must withdraw from the inherited IRA. The required minimum distribution (RMD) rules depend on your age and relationship to the deceased, but withdrawals are required even if the original IRA was a Roth IRA (which typically does not have RMD requirements).
What are The RMD Rules For Inherited IRAs?
When it comes to required minimum distributions, different rules apply to spouses and non-spouses.
One recent difference between the rules for spouse and non-spouse beneficiaries is a result of the SECURE Act, established in early 2020. It states that non-spouse beneficiaries have to withdraw all the funds from their inherited IRA within a maximum of 10 years. After that time, the IRS will impose a 50% penalty tax on any funds remaining.
Spouses, on the other hand, can enjoy the benefits of what’s called a “stretch IRA”. You take yearly distributions from the account based on your own life expectancy, even if the original owner was older than 72. In this way, you “stretch” the distributions to match your lifetime, rather than that of the original account holder.
RMD Rules for Spouses
Once a spouse takes ownership of the deceased’s IRA account, they can either roll the assets into their own pre-existing IRA within 60 days, or transfer funds to their newly opened inherited IRA, they can withdraw based on their age.
Note that taking a distribution from the account if you are under age 59 ½ results in a 10% early withdrawal penalty.
RMD Rules for Non-Spouses
For non-spouses (relatives, friends, and grown children), once you’ve opened an inherited IRA and transferred the inherited funds into it, RMDs must start before December 31st following a year from the death. All assets must be withdrawn within 10 years, though there are some exceptions: if the heir is disabled, more than a decade younger than the original account owner, or a minor.
How Do I Avoid Taxes on An Inherited IRA?
Money from IRAs is generally taxed upon withdrawals, so your ordinary tax rate would apply to any tax-deferred IRA that was inherited — traditional, SEP IRA, or SIMPLE IRA.
However, if you have inherited the deceased’s Roth IRA, which allows for tax-free distributions, you should be able to make withdrawals tax-free, as long as the original account was set up at least five years ago.
Spouses who inherit Roth accounts have an extra opportunity to mitigate the bite of taxes. Since spousal heirs have the power to take ownership of the original account, they can convert their own IRA into a Roth IRA after the funds roll over. Though the spouse would be expected to pay taxes on the amount converted, it may ultimately be financially beneficial if they expect higher taxes during their retirement.
Recommended: Is a Backdoor Roth IRA Right For You?
Once you inherit an IRA, it’s up to you to familiarize yourself with the inherited IRA rules and requirements that apply to your specific situation. No matter what your circumstance, inheriting an IRA account has the potential to put you in a better financial position in your own retirement.
SoFi Invest® offers Traditional, Roth, and SEP IRAs. And investors curious about other investment opportunities can also explore active or automated investing with SoFi.
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