What To Do If You Inherit an IRA
Losing a loved one can bring not only an emotional burden but also significant financial responsibilities related to settling the estate. If you are a beneficiary to retirement plan assets, you may inherit control of all or part of a retirement plan account. So, what exactly can one do with an inherited Individual Retirement Account (IRA) or a Roth IRA? What responsibilities do you have to the newly inherited account? The answers to these questions may depend on your relationship to the deceased. Here I will discuss several factors that will determine what you can do with inherited retirement assets.
Some terminology you should be familiar with includes Required Minimum Distribution and Required Beginning Date. Required Minimum Distributions (or “RMDs”) are withdrawals that the IRS requires you to take from tax-deferred accounts (such as IRAs). These are calculated each year using the value of an account on December 31st of the prior year and a “life expectancy factor,” which is based on IRS Life Expectancy tables.
The Required Beginning Date (RBD) is the date by which a person is required to start taking these Required Minimum Distributions. Typically, this date is April 1st following the calendar year in which the account owner reaches age 70½. For example, if the account owner’s 70th birthday is February 28, 2017, they turned 70½ on August 28, 2017 and must therefore begin RMDs on April 1st, 2018. It is important to note that the RBD may be different for inherited accounts, which may be dependent on the rollover strategy and the age of the deceased person.
A Spouse as Primary Beneficiary has Several Options for an Inherited Account
If you are the primary beneficiary of your spouse’s retirement assets, you can generally treat inherited assets as if they are your own. A spouse has several options to consider in determining what do with an inherited retirement account.
Option 1: Withdraw inherited assets as a lump-sum
Perhaps the most straight-forward option, a spouse who inherits retirement assets can choose to withdraw the entire sum of the account at once. Depending on the original retirement account type, the withdrawal may be subject to income taxes. If the sum withdrawn is large enough, this lump-sum may even move you into a higher tax bracket, which would subject you to paying higher income taxes on the transaction. If the IRA in question is a Roth IRA, a lump-sum withdrawal will be tax-free so long as the mandatory five-year holding period has already been met. This rule dictates that five tax years must pass after the first contribution to a Roth IRA before the first distribution can be made without penalty. Ensure your spouse has met the five-year rule to avoid unexpected taxation on Roth IRA withdrawals.
Option 2: Transfer inherited assets directly to your Traditional or Roth IRA
Perhaps the easiest option is simply to transfer assets from your spouse’s account to your own Traditional or Roth IRA. When transferring assets to your own IRA, distribution rules are the same as if the assets had been yours in the first place. Therefore, if you roll the assets into a Traditional IRA in your name, you’ll have to take your first RMD by April 1st following the calendar year in which you turn age 70½. If you roll the assets into a Roth IRA, you will never be subject to required minimum distributions.
The disadvantage to this option comes if you are not at least age 59½ and you plan to draw money out of the IRA sometime in the near future. Just like regular Traditional IRA rules, any withdrawals before age 59½ are subject to a 10% penalty tax. So, if you’re needing to take money out of the account, it may be best to transfer the assets into an inherited IRA.
Note that if your spouse had a traditional IRA (or otherwise pre-tax account), you do have the option to roll this into a Roth IRA in your name. The entire amount, however, will be added to your gross income for the year and you’ll have to pay ordinary income taxes on that amount. One may choose to do this if the benefits (tax-free income later and never any RMDs) outweigh the costs (paying taxes on the entire amount today).
Option 3: Transfer assets into an inherited IRA
In addition to transferring inherited IRA assets directly into your personal IRA, you can also create a new “inherited IRA” account in your name. Though very similar to transferring to your own account, this method avoids the 10% penalty tax for withdrawals before age 59½. If you choose this option, the RMD will depend on whether or not your spouse had reached his or her RBD yet. For example, if your spouse passed away at age 75, and you choose to roll over his or her assets into a Traditional IRA, you must begin taking distributions from the account by December 31st of the year following your spouse’s death. These distributions will be calculated using your life expectancy factor.
Alternatively, if your spouse passed any time before age 70½, you may have the option to defer RMDs until your spouse would have turned age 70½. These distributions will be calculated using your spouse’s life expectancy factor, due December 31st each year. There is also what’s referred to as the “5 Year Method,” in which the spouse plans to liquidate the entire account by December 31st of the fifth year after the year in which the account owner passed away.
Non-Spouse Beneficiaries Must Abide by a Different Set of Rules for Inherited Accounts
A beneficiary that is not the spouse of the deceased – i.e., siblings, children, close friends – may not treat the account as if it is their own. This type of beneficiary can either open an Inherited IRA and be subject to RMDs, or withdraw the assets as a lump sum.
Two methods for transferring inherited assets: Inherited IRA or Inherited Roth IRA
If the inherited IRA is a Roth IRA, and you are a non-spouse beneficiary, you become subject to RMDs. These must begin by December 31 of the year following the original account owner’s passing. In these instances, RMDs are based on the beneficiary’s life expectancy factor, not the original account owner’s. The beneficiary also has the option of choosing the 5 Year Method mentioned above.
With Inherited Traditional IRAs for non-spouse beneficiaries, the options depend on whether the original account owner was over or under age 70½ at the time of passing. If the original account owner was age 55 at the time of passing, for example, the beneficiary may choose to use the 5 Year Method for distributions, or he or she may base RMDs on his or her life expectancy factor. The 5 Year Method for distributions is not available if the original account owner was over age 70½.
Lump-sum distribution for non-spouse beneficiaries
The lump sum option is always an option for non-spouse beneficiaries, regardless of Roth vs. Traditional or the age of the deceased. Roth IRA accounts that have met the five-year rule will enjoy tax-free distribution while Traditional IRAs will be subject to the normal income tax rates.
For all of the options outlined above, it is best to consult a financial advisor in order to protect yourself from unexpected tax burdens.
Multiple Beneficiaries of Inherited Assets Must Act Independently
When a retirement account contains multiple beneficiaries, they are each treated as if their relationship to the original owner is non-spousal. Each beneficiary must transfer their portion of the assets into a new Inherited IRA and continue RMDs based on the life expectancy of the new owner. If the beneficiaries do not allocate the assets into individual retirement accounts by December 31st of the year following the death of the original account owner, then RMDs must continue based on the life expectancy of the oldest member of the beneficiary group. It is thus advised that assets are distributed to new Inherited IRAs as soon as possible, as each beneficiary will calculate their RMD individually.
Inherited Retirement Accounts Present Opportunities for Financial Gain for Beneficiaries
The various options available to those who inherit a retirement account with considerable assets each contain their own caveats. Paying attention to the tax implications of each option is an important aspect for account beneficiaries. To be safe from paying more taxes than is required, consider all of your options with a trusted financial advisor who is trained to understand the nuances of these financial inheritances.
Bronfman E.L. Rothschild is a registered investment advisor (dba Bronfman Rothschild). Securities, when offered, are offered through an affiliate, Bronfman E.L. Rothschild Capital, LLC (dba BELR Capital, LLC), member FINRA/SIPC.
This information should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The commentary provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Bronfman Rothschild cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use. Past performance does not guarantee future results. © 2017 Bronfman Rothschild