What is an inherited IRA?

An inherited IRA is a particular type of retirement account you open when you inherit a tax-advantaged retirement plan, such as an IRA or employer-sponsored plan. This happens when the former owner of the plan passes away and has designated you the heir to their plan.

You can inherit anyone’s IRA. However, there are a few things to keep in mind if you receive one. Firstly, the rules differ depending on whether or not the original owner was your spouse. Additionally, becoming the beneficiary of an inherited IRA is not a simple process. Typically, you will be required to open up a new IRA account in your name and transfer the original owner’s assets from their account to yours.

What’s more, as with any other type of IRA, certain restrictions come with an inherited IRA. Depending on your circumstances and personal preferences, you may want to consider several factors before deciding whether to accept this kind of inheritance.

For example, you’ll need to make some choices to avoid accidentally violating IRS regulations, and there are specific errors and oversights you will need to be aware of unless you want to create delays or incur penalties. Furthermore, you may be able to take advantage of tax breaks and other opportunities to lower costs and avoid issues.

What happens when you inherit an IRA?

One of the most important things to point out right off the bat about an inherited IRA is that you may not be able to make any more contributions to the account after receiving it. Most beneficiaries can only take distributions and must do that according to precise rules.

For example, most beneficiaries have only ten years following the original owner’s death to liquidate the account of all funds due to a new rule imposed by the SECURE Act. There are several ways of complying with the ‘Ten-Year Rule,’ each with different tax ramifications.

There are also some exceptions to the rule, including:

  • The original IRA owner’s surviving spouse.
  • The original IRA owner’s minor child. (Once the minor reaches the age of maturity, however, they become subject to the ten-year rule.)
  • An individual who is not more than ten years younger than the IRA owner.
  • A disabled or chronically ill person, as determined by the IRS.

More good news: If you are excepted from the ten-year rule, you can also make contributions and take distributions to the account just as if you’d opened it yourself. Essentially, suppose you fall into one of the above categories. In that case, you may be able to treat the assets as if they are your own, per the rules that govern that type of IRA (for example, you must follow the rules for a Traditional versus a Roth IRA).

Furthermore, if you are the surviving spouse, you can also choose to treat the IRA as your own by rolling it over into your IRA, or to the extent that it is taxable, into a:

  • Qualified employer plan
  • Qualified annuity plan (section 403(a) plan)
  • Tax-sheltered annuity plan (section 403(b) plan)
  • Deferred compensation plan of a state or local government (section 457 plan).

You may also treat yourself as the beneficiary rather than treating the IRA as your own.

On the other hand, if you are not exempt from the ten-year rule, you still have choices when inheriting an IRA.

Suppose you do not wish to transfer the funds into your account. In that case, you can immediately take the inheritance in a lump sum — but consider that you could end up paying income taxes on the taxable portion of that sum, which in turn could move you into a higher tax bracket with higher rates.

On the subject of tax liability…

Do you need to pay taxes on an IRA inheritance?

An IRA is a tax-advantaged retirement account. That means that contributions made to an IRA throughout the owner’s life are pre-tax, meaning that only withdrawals from the account are taxed.

Unfortunately, withdrawals may be taxed at your ordinary income tax rates if you are the beneficiary of a Traditional IRA. Roth IRAs, on the other hand, are typically funded with taxed contributions, meaning withdrawals are not subject to tax. You can even combine an inherited Roth IRA with another Roth IRA you maintain, provided you either:

  • Inherited the other Roth IRA from the same decedent, or
  • Were the decedent’s spouse and the sole beneficiary of the Roth IRA and elect to treat it as your own IRA.

There are some exceptions for Roth IRA beneficiaries. If you are the deceased’s spouse and decide to roll the IRA into your own, withdrawn earnings on the account will be taxable until you reach age 59 ½ and until a five-year holding period is complete. Similarly, if you take a lump sum distribution from a Roth IRA before the five-year holding period is complete, your withdrawal will also be taxable in those circumstances.

Beneficiaries of a Traditional IRA are also not without options for limiting their tax liability. For example, an inherited IRA is part of the deceased person’s estate. That means that the estate tax may apply in the case of larger estates (worth more than $12.06 million as of 2022). Here’s the good news for you as a beneficiary: You can take a deduction for any estate taxes paid on the account, even if the estate, and not you, had to pay the tax. Additionally, you may be able to delay paying taxes until the end of the ten-year period, and, of course, you can make strategic tax planning choices about the timing of your withdrawals.

What are the rules for an inherited IRA?

As you may have gathered, the rules governing inherited IRAs are extraordinarily complex… even by IRS standards! Although this article has provided an overview of some options and considerations, there is more information on this subject we haven’t touched on.

For example, there are more rules that govern inherited Roth IRAs, you may encounter penalties for early withdrawals, and some distributions from Roth IRAs are not qualified, meaning they may add to your tax burden.

Ultimately, being the beneficiary of an inherited IRA is not the time to wing it — we strongly recommend seeking the advice and guidance of qualified financial professionals (like us).

Would you like some help?

If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.

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