Inherited IRA Distribution Rules Explained

By Ashley Kilroy · August 31, 2023 · 7 minute read

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Inherited IRA Distribution Rules Explained

When an IRA 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.

How does an inherited IRA work? 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. Plus there are inherited IRA distribution rules you’ll need to know.

An inherited IRA can also be a tremendous financial opportunity, as long as you understand the inheritance IRA rules. Here’s what you should know about the beneficiary IRA distribution rules.

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 — such as someone who inherited an IRA from a parent — 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.

💡 Quick Tip: Did you know that opening a brokerage account online typically doesn’t come with any setup costs? Often, the only requirement to open a brokerage account — aside from providing personal details — is making an initial deposit.

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, child, 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 inherited IRA distribution rules, as can the age of the deceased at the time of death, certain inheritance IRA 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 according to inherited Roth IRA distribution rules, 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, there are different rules for inherited IRA RMDs for 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 take yearly distributions from the account based on their own life expectancy.

RMD Rules for Spouses

Once a spouse takes ownership of the deceased’s IRA account, they can either roll over 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 who inherited an IRA from a parent), once you’ve opened an inherited IRA and transferred the inherited funds into it, RMDs generally must start before December 31st following a year from the person’s 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.

💡 Quick Tip: Did you know that a traditional Individual Retirement Account, or IRA, is a tax-deferred account? That means you don’t pay taxes on the money you put in it (up to an annual limit) or the gains you earn, until you retire and start making withdrawals.

Multiple Beneficiaries

If there is more than one beneficiary of an inherited IRA, the IRA can be split into different accounts so that there is one for each person. However, in general, you must each start taking RMDs by December 31st of the year following the year of the original account holder’s death, and all assets must be withdrawn from each account within 10 years (aside from the exceptions noted above).

Inherited IRA Situation Examples

These are some of the different instances of inherited IRAs and how they can be handled.

Spouse inherits and becomes the owner of the IRA: When the surviving spouse is the sole beneficiary of the IRA, they can opt to become the owner of it by rolling over the funds into their own IRA. The rollover must be done within 60 days.This could be a good option for someone who is younger than the original owner of the IRA because it delays the RMDs until the surviving spouse turns 73.

Non-spouse designated beneficiaries: An adult child or friend of the original IRA owner can open an inherited IRA account and transfer the inherited funds into it. They generally must start taking RMDs by December 31 of the year after the year in which the original account holder passed away. And they must withdraw all funds from the account 10 years after the original owner’s death.

Both a spouse and a non-spouse inherit the IRA: In this instance of multiple beneficiaries, the original account can be split into two new accounts. That way, each person can proceed by following the RMD rules for their specific situation.

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?

The Takeaway

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.

Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

Help grow your nest egg with a SoFi IRA.

FAQ

Are RMDs required for inherited IRAs in 2023?

The IRS recently delayed the final RMD rule changes regarding inherited IRAs to calendar year 2024. That’s because rules regarding RMDs have changed in the last few years, leaving many people confused. What this means is that the IRS will, in some cases, waive penalties for missed RMDs on inherited IRAs in 2023 — but only if the original owner died after 2019 and had already started taking RMDs.

What are the disadvantages of an inherited IRA?

The disadvantages of an inherited IRA is knowing how to navigate and follow the many complex rules regarding distributions and RMDs, and understanding the tax implications for your specific situation. However, it’s important to realize that an inherited IRA is a financial opportunity and it could help provide you with money for your own retirement.

How do you calculate your required minimum distribution?

To help calculate your required minimum distribution, you can consult IRS Publication 590-B. There you can find information and tables to help you determine what your specific RMD would be.


Photo credit: iStock/shapecharge

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