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What To Do If You Inherit an IRA?

Americans have nearly $8 trillion dollars in IRA’s (individual retirement accounts). What should you do if you happen to inherit an IRA? The answer can vary depending on many factors such as one’s financial situation, the type of account they are inheriting (i.e. traditional or Roth IRA), and whom (i.e. parent or spouse) the IRA is inheriting from.

What are your options if you inherit a pre-tax IRA from a parent?

1. Lump Sum Distribution:

  • You can cash out the IRA completely however the full amount distributed will be taxed to you as ordinary income which could push you into a higher tax bracket.

2. Five-Year Method:

  • This option allows the beneficiary to withdrawal the funds over the course of five years.
  • There are no RMD’s (required minimum distributions)
  • After five years, any remaining funds will need to be withdrawn.

3. Life Expectancy Method:

  • You must start taking annual RMD’s by December 31st of the year after the death of the original owner passed away.
  • The distributions are much smaller and are calculated to last your expected lifetime.
  • If you fail to make the first distribution on time you will be forced to choose the five-year option and deplete your account within five years.
  • If you fail to distribute the required minimum distribution you will be hit with a 50% penalty on the amount taken below the RMD.
  • If multiple beneficiaries, separate accounts must be established by 12/31 of the year following the year of death; otherwise, distributions will be based on the oldest beneficiary.

The best distribution option, in most cases, would be the life expectancy method. By choosing this option, your inherited account will get extra years of tax-deferred growth. You can always take a distribution more than the required minimum in any given year as long as the required minimum distribution is taken each year.

Please note that the early distribution 10% penalty rules do not apply for inherited IRA’s received from a parent. However, if you inherited an IRA from a spouse and you elected to roll the assets into your own retirement account the early distribution penalty rules would apply.

What are your options if you inherit a Roth IRA account from a parent?

The same options as pre-tax Inherited accounts apply:

  • Lump Sum Distribution
  • Five-Year Method
  • Life Expectancy Method

However, since Roth IRA’s are funded with post-tax income, distributions are received from these accounts tax-free and will not push you into a higher marginal tax bracket.

A big thing to keep in mind is, earnings can be withdrawn tax-free on the first day of the fifth taxable year after the account was established.

For example, a Roth IRA established in 2014, the beneficiary must wait until January 1st, 2019 for earnings on distributions to be withdrawn tax-free.

There are many rules that apply to an individual inheriting an IRA.  To maximize the benefits of inheriting an IRA, please contact your Withum tax partner to discuss which distribution options would be best for your individual circumstance.

Author: Evan Finer, CPA  |  efiner@withum.com

If you have any questions information regarding inherited IRA’s, or other income tax questions, please contact a member of our Private Client Service Group.

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