The inheritance tax is one of the cruelest taxes that can make an unfortunate situation even more difficult.
One way to insulate you and your family from this untimely financial burden is to protect your remaining assets in an IRA. All remaining funds left in an IRA will be transferred to the beneficiary using a vehicle known as an inherited IRA, where the beneficiary can avoid paying taxes by following a few keen rules.
If you’re the owner of an inherited IRA, we’ve outlined a list of rules you need to follow to avoid penalties and unnecessary tax consequences. Here’s everything you need to know.
How Do Inherited IRAs Work?
Also known as a beneficiary IRA, an inherited IRA transfers funds from a deceased person’s IRA to an IRA in the name of the policy beneficiary.
Inherited IRAs share some rules and requirements with standard IRAs. For instance, once the funds are transferred to the inherited IRA, they continue to grow tax-free while in the account. Likewise, withdrawals from the account, including required minimum distributions (RMDs), are taxed if the original account was structured as a Traditional IRA. However, if the original account was a Roth IRA, withdrawals are not taxed.
Despite some similarities, there are key differences between inherited IRAs and standard IRAs.
- Inherited IRA owners cannot contribute funds to the account.
- RMDs are required, even for an inherited Roth IRA.
- Your relationship with the original account owner will dictate how you manage the account.
- Early withdrawals are not penalized unless you are a spouse. Otherwise, early withdrawal rules will be treated as if they were the original account holder.
Inherited IRA Distribution Rules: RMDs
Required minimum distributions, or RMDs, are a key part of many retirement accounts, including Traditional IRAs. In general, an individual who has a Traditional IRA must start taking required minimum distributions by April 1, the year following their 73rd birthday.
For inherited IRAs, the role of RMDs is two-fold. Whether or not the original account holder reached the age at which RMDs begin can determine what options an inherited account holder has. Further, in some situations, an inherited account holder may be required to take RMDs. This is true even if the original account was structured as a Roth IRA.
In the following section, we’ll discuss the inherited IRA rules for both spouses and non-spouse beneficiaries. But first, it’s beneficial to understand the basic rules set by the IRA and how they may affect RMDs.
5-year rule
The 5-year rule dictates that a beneficiary must deplete the inherited IRA account by December 31 in the year of the deceased’s 5th death anniversary. For instance, if an account owner died in 2019, the 5-year rule dictates that the inherited IRA account balance must reach zero by December 31, 2024.
For individuals considered non-spousal beneficiaries, this rule is only applicable if the original account owner died prior to 2020. That’s because the IRS took a new approach to inherited IRA RMDs with the passage of the SECURE Act in 2019. However, that act did not change rules for beneficiaries that were not individuals, such as trusts and charities. As such, non-individual beneficiaries are still subject to the 5-year rule if the original account owner died before RMDs started.
10-year rule
The 10-year rule dictates that an inherited IRA owner must deplete the account balance by December 31 in the year of the deceased’s 10th death anniversary. For example, if the original account owner died in 2023, the inherited IRA account must be depleted by December 3, 2033.
Under the 10-year rule, an inherited IRA account holder may be required to take RMDs during the first nine years of account ownership. However, some individuals, such as spouses and minor children, may be exempt from this requirement.
Lifetime distribution rules
Some beneficiaries who inherit an IRA will be able to take distributions based on their life expectancy.
Spouses who choose to keep the inherited IRA can choose when to begin taking RMDS based on their life expectancy. Typically, they must start taking RMDs by December 31 in the year the deceased would have been eligible for RMDs or the year after their spouse died, whichever is later.
Non-spousal beneficiaries who choose to take distributions based on their life expectancy must begin taking RMDs by December 31 in the year following the original account owner’s death. [Learn more: How Do I Calculate My Required Minimum Distribution?]
Spousal vs. Non-Spousal Beneficiary Rules
Once you inherit an IRA, you can typically access the funds in one of two ways: Lump sum withdrawals or distributions over a specific period of time. However, there are several IRS rules for inherited IRAs that further dictate your options.
Inherited IRA rules for spouses
Spouses have the most options when it comes to inherited IRAs. Two factors will determine what those options are: the year the spouse died and if they had to take RMDs before their death.
Spouse died before 2020 and RMDs did not begin before their death
| RMD Requirements | ||
| Keep as an inherited IRA |
| |
| Rollover into your own IRA |
| |
Spouse died before 2020 and was taking RMDs before their death
| Keep as an inherited IRA |
| |
| Rollover into your own IRA |
| |
Spouse died in 2020 or later and RMDs did not begin before their death
| Keep as an inherited IRA |
| |
| Rollover into your own IRA |
| |
Spouse died in 2020 or later and was taking RMDs before their death
| Keep as an inherited IRA |
| |
| Rollover into your own IRA |
| |
Inherited IRA rules for Non-Spousal Beneficiary
If you inherited an IRA from someone other than your spouse, your options depend on the year in which the original account holder died. If the account owner died prior to 2020, then their RMD status will impact your options.
If the account owner died in or after 2020, your options will also depend on whether or not you’re considered an eligible designated beneficiary.
To be considered an eligible designated beneficiary, you must be one of the following:
- Spouse of the deceased.
- Minor child of the deceased.
- Chronically ill or disabled.
- Someone who is no more than ten years younger than the deceased.
Account owner died before 2020
| RMDs did not begin prior to death or the account is a Roth IRA |
| |
| RMDs began prior to death |
| |
Account owner died in or after 2020
| Eligible designated beneficiary |
| |
| Designated beneficiary that is not considered “eligible” |
| |
| Beneficiary other than an individual (e.g., estate or trust) |
| |
How to Avoid Paying Taxes on Inherited IRAs
Though inheriting a windfall of cash can seem like a positive financial outcome, there can be significant and costly tax consequences. Primarily, a distribution can push you into a higher tax bracket and increase not only the tax on the distribution itself but also your income in that year.
Though you may not be able to avoid all tax consequences when inheriting an IRA, here are a few things you can do to lessen the impact.
Roll over the inherited IRA into your own IRA
If you’re the spouse of the deceased, you have the option to roll over the account into your own IRA, whether it’s a standard or self-directed IRA. Doing so can help you avoid taxes on the inherited IRA. Instead, the funds will transfer to your IRA and be taxed based on the account structure (Traditional or Roth). However, keep in mind that transferring a Traditional account to a Roth account will have tax implications.
Know the type of account you have
If you inherited a Traditional IRA, distributions will be taxed based on your income tax bracket. However, if you inherited a Roth IRA, taxes are not applied to the withdrawal, though the distribution can increase your tax bracket in that year.
Avoid taking a lump sum withdrawal.
You may not be able to avoid taxes altogether, but you can limit the impact of a withdrawal on your tax status. Taking a lump sum withdrawal will likely bump you into a higher tax bracket for the year in which you take it. Spreading it out for as long as IRS rules allow can decrease that burden.
Examine your income
If you think that your income will decrease in a certain year(s), consider structuring your distributions so that they are smaller in years when your income is higher and larger in years when your income may be lower.
Take note of the account age
If you inherit a Roth account, find out how long the account has been open. Withdrawals are commonly tax-free, but that’s not always the case. If the Roth account is less than five years old, then any withdrawal from earnings is subject to taxes.
Inheriting an IRA FAQs
Can spousal beneficiaries treat an inherited IRA as their own?
Yes, a spouse who inherited an IRA can treat the account as their own. If doing so, you must follow IRS rules as applicable to the account structure, such as paying taxes on distributions from a traditional IRA.
Can a beneficiary make additional contributions to an inherited IRA?
No, a beneficiary may not make additional contributions to an inherited IRA. This is true for both spousal and non-spousal beneficiaries. If you inherit your spouse’s IRA, however, you can roll the account into your own IRA and make contributions to that account.
Can a non-spouse beneficiary roll over the assets into an existing IRA?
No, a non-spousal beneficiary cannot roll over funds from an inherited IRA into their own IRA. This option is only available to spouses who inherit an IRA.
