Know the Rules on Inherited IRAs
Evaluate your situation before dipping into IRA assets from a deceased loved one.
This article originally ran in January 2011. In case you missed it, we're running it again as part of our IRA Improvement Week.
In a recent article, I discussed the ins and outs of required minimum distributions: who needs to take them, how to calculate how much to take, and which withdrawals make the most sense from an investment standpoint.
There's plenty of material right there, but taking RMDs from your own retirement account is a cakewalk compared with the distribution rules surrounding an IRA that you've inherited from someone else. Owners of inherited IRAs face distribution rules, too, but your options for the account vary depending on your relationship to the deceased (whether you're the spouse) as well as well as whether that person was age 70 1/2 and therefore had already begun taking required distributions from that account.
Thus, before taking action, those who inherit IRAs should answer the following questions:
Armed with the answers to those questions, you can then determine how best to proceed. Here's a rundown of the main scenarios under which someone may end up with an inherited IRA as well as the rules governing withdrawals in each situation. (Note that this article only tackles IRAs that are inherited directly by individuals--that is, not through a trust or by a charity. Nor does it tackle inherited assets from a qualified retirement plan, where the rules, especially for nonspouse beneficiaries, are different.) Because this topic is so complicated, it's best to consult with a financial or tax advisor before taking definitive action on an inherited IRA; Internal Revenue Service Publication 590 also provides a wealth of information on IRAs.
Scenario 1: Beneficiary of traditional IRA is a surviving spouse, and the deceased had not begun taking RMDs
Surviving spouses have a few key choices when they inherit traditional IRAs. One key avenue that nonspouse beneficiaries do not have is that surviving spouses can roll the IRA assets into their own IRA. Alternatively, they can take distributions directly from an inherited IRA. Furthermore, spouses who inherit an IRA (as with anyone who inherits an IRA) can choose to take the money in a lump sum.
Rolling over can be a good move in many instances, particularly for individuals who don't need the money in the IRA to fund living expenses. Doing so enables the surviving spouse to stretch out the tax-saving benefits of the IRA; the surviving spouse wouldn't have to take RMDs until he or she turns age 70 1/2. (At that time, the RMD rules that I outlined here would apply.) However, for younger surviving spouses who would like to tap the inherited IRA soon, a rollover won't be the right choice. That's because a 10% early-distribution penalty applies to any distributions taken before an IRA owner turns age 59 1/2.
In that case, leaving the assets in an inherited IRA is the better choice, but RMD rules apply here, as well. In the case of an inherited IRA where the deceased hadn't yet turned 70 1/2, the surviving spouse would need to take minimum distributions by the later of the following two dates: the end of the calendar year following the year in which the spouse died or the end of the calendar year in which the spouse would have turned age 70 1/2. The amount of the RMDs will hinge on the surviving spouse's own age.
If a surviving spouse of any age decides to receive the proceeds from an inherited IRA in a lump sum, it's a lot less complicated, but the inheritor will pay ordinary income taxes on the whole amount at that time.
Scenario 2: Beneficiary of traditional IRA is a surviving spouse, and the deceased had begun taking RMDs
Just as is the case when a spouse dies before starting to take RMDs, the surviving spouse who inherits an IRA from someone age 70 1/2 or older may roll over the retirement plan into his own IRA. The one difference is that if the beneficiary has not yet taken the required distribution for the year in which the owner died, that amount must be paid out before the surviving spouse rolls over the IRA into his own IRA. Again, younger surviving spouses will want to evaluate whether they might need the money before age 59 1/2 before rolling over an inherited IRA into their own. If they do need the money before that age, they'd be subject to the 10% penalty on early distributions.
If a surviving spouse decides to leave the assets in the inherited IRA account (that is, not roll them over) and the deceased had begun taking RMDs, the surviving spouse will need to begin RMDs, calculated based on the surviving spouse's own life expectancy, by Dec. 31 of the year of the deceased person's death. If the deceased hadn't yet taken his distribution for the year, the surviving spouse must take the distribution by the end of that year.
As in the previous scenario, lump-sum distributions from an inherited IRA from which the deceased had begun taking distributions would be taxed as ordinary income.
Scenario 3: Beneficiary of traditional IRA is not a spouse, and the deceased had not begun taking RMDs
If a person other than a spouse inherits a traditional IRA, rolling over the IRA is not an option. Instead, nonspouse beneficiaries can either take the money in a lump sum or take distributions from the inherited account. (Your financial-services provider will be able to walk you through the steps for opening an inherited IRA in your own name as well as naming your own beneficiaries and selecting your own investments.)
In the case of an inherited IRA where the deceased was under age 70 1/2 and hadn't begun taking RMDs, the beneficiary must start taking RMDs by Dec. 31 in the year following the year in which the deceased passed away. Alternatively, the beneficiary could delay distributions, as long as he withdraws all of the assets in the IRA within five years of the deceased person's death.
Scenario 4: Beneficiary of traditional IRA is not a spouse, and the deceased had begun taking RMDs
As in the previous case, rollovers are off-limits to nonspouse beneficiaries. Instead, beneficiaries can take the assets in a lump sum or take distributions from an inherited IRA account during the beneficiary's own lifetime. RMDs must begin by Dec. 31 following the year of the deceased person's death. If the deceased did not take his or her RMD for the year in which he died, distributions must be made by year-end.
Scenario 5: Beneficiary of Roth IRA is a spouse
As with traditional IRAs, spouses who inherit Roths have more flexibility than nonspouse beneficiaries. Anyone who takes a lump-sum distribution from a Roth IRA won't owe taxes, assuming the assets have been in the account for five years following the contribution. Alternatively, spouses can roll their inherited Roth IRA into other Roth IRA assets or leave the inherited Roth IRA account intact and take distributions from it directly; in both cases, distributions would be tax-free, assuming the five-year requirement was met. The rollover is generally preferable, however, in that mandatory distributions wouldn't apply.
Scenario 6: Beneficiary of Roth IRA is not a spouse
Nonspouse beneficiaries of Roth IRAs are subject to more rules than are spouse beneficiaries. In particular, nonspouse beneficiaries cannot roll the inherited IRA assets into their own IRAs. Nonspouse beneficiaries can, however, take the assets in a lump-sum distribution. RMDs apply to all other Roth IRA assets inherited by nonspouse beneficiaries: The beneficiary must receive the entire distribution by Dec. 31 of the fifth year following the year of the owner's death or elect to receive distributions during the beneficiary's own life expectancy.
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