I received a lot of email after my recent article on required minimum distributions (RMDs), the IRS-mandated withdrawals you normally must make from a traditional IRA once you turn 70½. While that kind of feedback isn’t unusual, it was a surprise that so many asked about the rules for someone who inherits an IRA. Inheriting an IRA is becoming more common as the first of the "IRA generation" gets older, and many of us may need to know these rules someday.
Inheriting an IRA certainly can be a financial boost, but it also presents opportunities for costly missteps. Given those, your first step should be to talk with a tax professional or your financial advisor to review your options.
Although not an exhaustive list, here are five things you should understand if you inherit an IRA.
Both Roth and traditional IRA beneficiaries are subject to RMD rules. A Roth IRA account owner doesn’t have to take RMDs; however, if you’re a beneficiary of a Roth IRA, you do.
“Stretching” can extend tax benefits. The IRS allows beneficiaries to set up an inherited IRA and take distributions based on their life expectancy. If you want to take advantage of this option, the first distribution must be made by Dec. 31 of the year following the owner’s death. To make the calculation, you’ll divide the account value by your life expectancy from the IRS Single Life Expectancy Table in the first year, then subtract one from that number each subsequent year. For example, a 40-year-old who inherited a $100,000 traditional IRA would be required to pull out and pay tax on about $2,300 ($100,000/43.6). This rule would also allow you to extend the tax-free benefits of a Roth IRA. The life expectancy option doesn’t limit how much you could take out — the beneficiary could later decide to withdraw 100%. This choice provides the most flexibility for non-spouse beneficiaries.
Be aware of the five-year rule. If you miss the deadline noted above and the original owner was younger than 70½, you’ll default to the five-year rule. Under this scenario, you’re not required to take distributions each year, but you must withdraw the entire account by Dec. 31 of the year in which the fifth anniversary of the account owner’s death occurs.
A spouse has more options. A spouse beneficiary can take the proceeds as their own IRA or set up an inherited IRA. If they treat it as their own, the proceeds would be subject to the normal RMD rules. With an inherited IRA, you would need to begin life expectancy distributions Dec. 31 of the year after your spouse’s death or Dec. 31 of the year when your spouse would have turned 70½, whichever comes later. A spouse might set up an inherited IRA — rather than taking it as their own — if they were younger than 59½ and wanted access to the money without paying the 10% early withdrawal penalty that could come with pulling money out of their own IRA.
Rules for moving an inherited IRA are different. Unlike an owner who can normally withdraw money and move it to a new IRA within a 60-day period as a rollover, inherited IRAs can only be transferred directly from one custodian to another. This is important if you inherit an IRA and want to move it to
