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You’ve just inherited an IRA. Now what do you do?

by | Blog

Written by: Spencer Salvador

This post was originally published on our previous blog website on August 29, 2017 and has since not been revised and/or updated. 

This week’s post is part one of a two-part series on inherited IRA’s, written by Spencer Salvador in our Seattle, WA office.  This week will look at inheriting an IRA from a spouse.  Next week’s post will review inheriting an IRA from someone other than a spouse.  Take it away, Spencer!

When I thought of writing an article about inherited IRAs I overlooked the fact that it’s a morbid topic. Sorry about that, I promise I’m usually a cheerful person. Hopefully you find this useful rather than morbid. I also didn’t realize it was such a complex topic to put into writing. Once you’ve reached the part where I outline the different options one has with inherited IRAs feel free to skip to the section that is applicable to you or the section you’re most interested in learning about.

In the event you’ve directly inherited an IRA it’s probably the result of something unfortunate that happened. Father time is undefeated and the passing of loved ones, often times with leftover assets, is inevitable. Rather than getting sentimental or reminiscing on the all the good times, let’s address the “now what?” question which will eventually arise.

In some cases, finding out you’ve just inherited an IRA can come as a surprise. Ideally, you know in advance that you’ll be a beneficiary of an IRA if a loved one passes away. If you are aware that you’re listed as a beneficiary on someone’s IRA account I suggest educating yourself on your options and have a plan in place if/when you inherit the account. Also, use your financial advisor as a resource when making your decision. That way, you’ll already know the answer to that “now what?” question and will hopefully be able to avoid making an irrational decision on what to do.

So, whether you know you’re listed as a beneficiary and are looking to have a plan in place or you’ve just inherited an IRA and are trying to figure out what do, the following context should give you a solid outline of what your options are.

Things to Consider

  1. The type of IRA you’ve inherited
    • Pre-tax IRA – traditional, SEP IRA, or SIMPLE IRA
    • Post-tax IRA – Roth IRA
  2. The age of the person you inherited the IRA account from
    • Required Beginning Date (RBD) – IRAs generally require a person to begin receiving distributions from the account at a certain age. The year and date you must begin receiving these distributions is based on the original account holder’s age.
    • Required Minimum Distributions (RMDs) – most IRAs also have a minimum amount that needs to be withdrawn from the account on annual basis. The RMD is typically based on the inheritor’s life expectancy and the value of the IRA at the end of each year.
  3. Your financial goals
    • Access – in some circumstances, the passing of a loved one could cause financial hardship so it’s important to evaluate your current financial situation and goals moving forward to determine whether or not you’ll need to access a portion or all of the account in the foreseeable future.
    • Accumulation – for some, there is no immediate need for the inheritance so even inheriting a modest amount can turn into a considerable legacy left over time.

Directly inherited from a spouse

Pre-Tax IRA – Traditional IRA, SEP IRA, SIMPLE IRA

If you’ve inherited a pre-tax IRA from your spouse there’s three main options for what to do. The decision, in large part, comes down to your financial goals and current situation.

Option 1: Transfer the account to your own Traditional IRA

*Please note there are special requirements for actions under this option

  • Benefits:
    • The assets in the account can continue to grow tax-deferred over time.
    • You are able to designate your own beneficiaries in the event you pass before taking full distributions.
    • Traditional IRA assets up to $1 million are often protected from creditors.
  • Actions:
    • Talk to your financial advisor before making this decision on your own.
    • If you are the sole beneficiary of the account all you’ll need to do is transfer the assets into your own existing Traditional IRA or open a new IRA if you don’t have one.
      • Be sure to review the allocation so it is appropriate for your goals and time horizon.
    • If the account is to be split amongst multiple beneficiaries you’ll need to take your share from the account as a distribution and deposit the assets into your Traditional IRA within 60 days of taking the distribution.
      • Be sure to review the allocation so it is appropriate for your goals and time horizon.
    • Accessing the money:
      • Money in Traditional IRAs is available at any time; however, if you take distributions prior to reaching age 59 ½ a penalty will apply unless you meet one of the IRS penalty exceptions.
      • Once you’ve reached age 70 ½ your Traditional IRA account will be subject to annual RMDs based on your life expectancy.
      • Most distributions are taxable as income when withdrawing the money.

Option 2: Transfer the account to an Inherited IRA

  • *Please note there are special requirements for actions and accessing the money under this option

    • Benefits:
      • The assets in the account can continue to grow tax-deferred over time.
      • You are able to designate your own beneficiaries in the event you pass before taking full distributions.
      • You do not have to pay an early withdrawal penalty when receiving distributions prior to 59 ½.
    • Actions:
      • Talk to your financial advisor before making this decision on your own.
      • If you are the sole beneficiary of the account all you’ll need to do is transfer the assets into an Inherited IRA held in your name.
        • Be sure to review the allocation so it is appropriate for your goals and time horizon.
        • The account registration should include your spouse’s name, an indication that the account is an IRA beneficiary distribution account, and your (the inheritor’s) name.
      • If the account is to be split amongst multiple beneficiaries you’ll need to establish a separate account by December 31st following the year of death to use your own life expectancy for RMDs. If you miss this deadline, the RMDs will be calculated using the oldest beneficiary’s life expectancy.
        • Be sure to review the allocation so it is appropriate for your goals and time horizon.
      • Accessing the money:
        • Money in Inherited IRAs is available at any time without an early withdrawal penalty.
        • Most distributions are taxable as income when withdrawing the money.
        • RMDs depend on whether or not your spouse reached age 70 ½
          • Spouse was over 70 ½ years old:
            • RMDs must begin by December 31st of the year after death.
            • If your spouse did not take an RMD for the year they passed away, you must take the RMD before the end of the year in which they passed.
          • Spouse was under 70 ½ years old:
            • RMDs must begin by the later of December 31st following the year of your spouse’s passing, or December 31st of the year in which your spouse would have reached 70 ½
            • You may also use the five-year rule, which allows you to take a full distribution of the account by December 31st of the 5th year after the year of your spouse’s death.

Option 3: Receive a lump-sum distribution

  • Benefits:
    • You do not have to pay an early withdrawal penalty when receiving distributions prior to 59 ½.
  • Actions:
    • Talk to a tax professional and your financial advisor before making this decision on your own.
    • Transfer the assets into an account in your name and take an immediate lump sum distribution.
  • Accessing the money:
    • Money is distributed in a lump-sum all at once.
    • Most distributions are taxable as income when withdrawing the money which may move you into a higher income tax bracket in the year distributed.

Post-Tax IRA – Roth IRA

If you’ve inherited a pre-tax IRA from your spouse there’s three main options for what to do. The decision, in large part, comes down to your financial goals and current situation.

Option 1: Transfer the account to your own Roth IRA

*Please note there are special requirements for actions under this option

  • Benefits:
    • The assets in the account can continue to grow tax-free over time.
    • You are able to designate your own beneficiaries in the event you pass before taking full distributions.
    • Roth IRA assets up to $1 million are often protected from creditors.
    • You do not have to take RMDs from your own Roth IRA.
  • Actions:
    • Talk to your financial advisor before making this decision on your own.
    • If you are the sole beneficiary of the account all you’ll need to do is transfer the assets into your own existing Roth IRA or open a new Roth IRA if you don’t have one.
      • Be sure to review the allocation so it is appropriate for your goals and time horizon.
    • If the account is to be split amongst multiple beneficiaries you’ll need to take your share from the account as a distribution and deposit the assets into your Roth IRA within 60 days of taking the distribution.
      • Be sure to review the allocation so it is appropriate for your goals and time horizon.
    • Accessing the money:
      • Money in Roth IRAs is generally tax and penalty free after reaching age 59 ½ and you have met the five-year holding period (outlined above).
      • If you haven’t met the five-year holding period or haven’t obtained age 59 ½ distributions can be subject to IRS penalties and in some cases taxes.

Option 2: Transfer the account to an Inherited Roth IRA

  • *Please note there are special requirements for actions and accessing the money under this option

    • Benefits:
      • The assets in the account can continue to grow tax-free over time.
      • You are able to designate your own beneficiaries in the event you pass before taking full distributions.
      • You do not have to pay an early withdrawal penalty when receiving distributions prior to 59 ½.
    • Actions:
      • Talk to your financial advisor before making this decision on your own.
      • If you are the sole beneficiary of the account all you’ll need to do is transfer the assets into an Inherited Roth IRA held in your name.
        • Be sure to review the allocation so it is appropriate for your goals and time horizon.
        • The account registration should include your spouse’s name, an indication that the account is an IRA beneficiary distribution account, and your (the inheritor’s) name.
      • If the account is to be split amongst multiple beneficiaries you’ll need to establish a separate account by December 31st following the year of death to use your own life expectancy for RMDs. If you miss this deadline, the RMDs will be calculated using the oldest beneficiary’s life expectancy.
        • Be sure to review the allocation so it is appropriate for your goals and time horizon.
      • Accessing the money:
        • Money in Inherited Roth IRAs is available at any time without an early withdrawal penalty.
        • Money in Inherited Roth IRAs is generally tax-free as long as assets have met the five-year holding period.
        • RMDs must begin by the later of the following:
          • December 31st following the year of your spouse’s death, or
          • December 31st of the year when your spouse would have reached age 70 ½
          • You may also use the five-year rule, which allows you to take a full distribution of the account by December 31st of the 5th year after the year of your spouse’s death.

Option 3: Receive a lump-sum distribution

  • Benefits:
    • You do not have to pay an early withdrawal penalty when receiving distributions prior to 59 ½.
  • Actions:
    • Talk to a tax professional and your financial advisor before making this decision on your own.
    • Transfer the assets into an account in your name and take an immediate lump sum distribution.
  • Accessing the money:
    • Money is distributed in a lump-sum all at once.
    • Money is generally tax-free as long as assets have met the five-year holding period.

 

That wraps up this weeks post.  Tune in next week where Spencer dives into inheriting an IRA from a non-spouse, such as a parent or grandparent.  

 

Disclosure:

 This is not to be construed as individualized financial or investment advice. Consult with your financial advisor for specific recommendations regarding your particular circumstances.    

 Financial Advisors do not provide specific tax/legal advice and this information should not be considered as such. You should always consult your tax/legal advisor regarding your own specific tax/legal situation.