Inherited IRAs: Rules on How to Manage and Withdrawal Funds

As you get older, a friend or relative may pass away and list you as the beneficiary of their accounts.

If they had an IRA, you’ll have access to those funds, even if you’re years away from retirement age yourself. 

In most cases, you’ll have to open an inherited IRA to transfer those assets.

But how you can handle the money and how its taxed depends on the type of IRA left to you, your relationship to the deceased, and the age of your loved one when they passed away.

Here is what you need to know about inherited IRAs and how to open one.

Inherited Funds Must Find New Home

If your loved one passed away and you inherit their IRA, you can’t leave the money where it is.

Instead, your options are to:

  • transfer the inherited money into an IRA in your own name
  • open an inherited IRA
  • take a lump-sum distribution.

Depending on your relationship with the deceased and their age when they died, you may have to start taking required minimum distributions (RMDs) as well. 

What is an Inherited IRA?

An inherited IRA — also known as a beneficiary IRA — is an account you open when you inherit an IRA after the original owner passes away.

When a friend or relative dies and lists you as the beneficiary, you can transfer their traditional, Roth, SEP, or SIMPLE IRA account into an inherited IRA held in your name.

You can inherit an IRA from your spouse, a parent, or even a friend.

Are There Required Minimum Distributions (RMDs)?

The RMD is the minimum amount of money you must withdraw from a retirement account each year.

In general, you have to start taking withdrawals from your IRA when you reach 70½, but Roth IRAs don’t require withdrawals until the account owner dies

If you need extra money, you can withdraw more than the RMD if you wish. However, keep in mind that withdrawals are included in your taxable income. 

When you don't take RMDs

RMDs are important to remember.

If you don’t take out the full RMD by the deadline, the amount not withdrawn is taxed at 50%, which can significantly cut into your assets. 

For inherited IRAs, when you need to start taking RMDs is dependent on the original account owner’s age on the date of their death. 

There are two methods for calculating the RMD with an inherited IRA: 

1. Life-expectancy method

With the life-expectancy method, you withdraw money from your IRA each year based on IRS calculations.

2. Five-year method

Available to spouses, this method requires you to receive the entire balance of the IRA by the end of the fifth year after the year of your spouse’s death.

Rules for a Spouse Beneficiary

If you’re the spouse of the deceased, and your partner was under the age of 70½, you have the following options when dealing with a traditional, SEP, or SIMPLE IRA:

Transfer the funds into your own IRA

If you are the sole beneficiary of the IRA, you can transfer the assets into your current or new IRA, where the money will grow tax-deferred.

You can access the funds at any time, but a penalty will apply to withdrawals made before you reach age 59½.

After you turn 70½, you will have to take RMDs based on your life expectancy.

Open an Inherited IRA

You can transfer the funds into an inherited IRA opened in your name.

With this option, you don’t have to pay a 10% early withdrawal penalty, and the assets can continue to grow tax-deferred.

If the original account holder was under 70 ½, RMDs must begin by the later of:

  • December 31 following the year of the original account holder’s death, or
  • December 31 of the year in which the original account holder would have reached age 70 ½. 

If the account holder was 70 ½ or older, RMDs must begin by December 31 of the year after death. 

Take a lump-sum distribution

You can transfer the funds into an account in your own name, then distribute as a lump sum.

You won’t have to pay an early withdrawal penalty, but you will have to pay income taxes on the taxable portion of the distribution.

Now:

If your spouse had a Roth IRA, the rules are different, but you still have three options:

Transfer the assets to your own Roth IRA

Transfer the funds into a new or existing Roth IRA, and your assets will grow tax-free.

There are no required minimum distributions (RMDs), and you can access the funds at any time.

Transfer the funds into an inherited Roth IRA

With this approach, you transfer the funds into an inherited Roth IRA in your name.

The assets will grow tax-free, and you avoid the 10% early withdrawal penalty.

Take a lump-sum distribution

Transfer the assets into an account in your own name, then distribute the funds as a lump sum.

You won’t have to pay an early withdrawal penalty with this option.

Rules for Non-Spouse Beneficiaries

If you are not the spouse of the deceased but are instead a friend or family member, you have the following two options with traditional, SEP, or SIMPLE IRAs:

Transfer the assets to an inherited IRA

With this option, you transfer the assets into an inherited IRA in your own name.

The assets will grow tax-deferred and you won’t have to pay a 10% early withdrawal penalty.

  • If the original account holder was under 70½, you will have to take out RMDs no later than December 31 of the year after they died.
  • If the original account holder was over the age of 70½, RMDs must start by December 31 of the year after death.

Take a lump-sum distribution

You can transfer the funds into an account in your own name and then take a lump-sum distribution.

You won’t have to pay an early withdrawal penalty, but you will have to pay taxes on the taxable portion, which may move you into a higher tax bracket.

Now:

If your friend or relative listed you as the beneficiary on a Roth IRA, you have the following options:

Transfer the assets to an inherited IRA

You can transfer the assets into an inherited IRA opened in your own name.

By doing so, the assets can grow tax-free, and you avoid the early withdrawal penalty.

Take a lump-sum distribution

You can transfer the funds into an account in your own name, then distribute it as a lump sum.

You won’t have to pay an early withdrawal penalty.

How to Open an Inherited IRA

First, contact the account owner’s investment company to notify them about your loved one’s passing.

They will be able to stop any automatic services, such as monthly contributions, and can prevent unauthorized transactions or fraud.

They will confirm that you were the sole beneficiary, and begin the proceedings to transfer the assets to you. 

Then, you can open an inherited IRA with most brokerage firms, including:

  • Vanguard
  • Fidelity Investments
  • Charles Schwab
  • TD Ameritrade
  • E*TRADE
  • Merrill Edge

You can may even choose to use robo-advisory providers for inherited IRAs.

To open an inherited IRA, you’ll need to contact the firm’s support team via email or phone.

You’ll need to provide them with:

  • the account’s current provider
  • type of IRA
  • account number
  • account owner’s name

You’ll likely have to send them a copy of the deceased’s death certificate, which you can get from the funeral home.

Managing an Inherited IRA

If you open an inherited IRA, you can’t make additional contributions to the fund.

However, you can choose different investment options for the money already invested, including a range of mutual funds, stocks, bonds, or ETFs. 

Conclusion

When you’re dealing with the passing of a loved one, dealing with their retirement accounts may be the last thing on your mind.

However, it’s important to take action when you’re able to do so.

By opening an inherited IRA, you can ensure the money continues to grow, increasing your own retirement nest egg.

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