IRAs were created to encourage people to save for retirement. Because they have tax advantages, they’re regulated by the IRS. (You can find information about IRAs, including details about inheriting an IRA, in IRS Publication 590-A.)
An option for a surviving spouse
When you inherit an IRA, you may be eligible for certain tax benefits—but your eligibility depends on whether you’re a spouse or a “nonspouse” (a beneficiary who wasn’t married to the original account owner at the time of death).
If you’re a spouse, you can “assume” the IRA, which means you can transfer the assets into an IRA in your name and the IRS will treat the IRA as if it had always been yours. You’ll get the same tax advantages (and will be subject to the same required distribution rules, including the 10% federal penalty on any distributions taken before age 59½) as the original account owner.
If you assume the IRA, the assets will be protected by federal law from creditors if you declare bankruptcy. (In 2014, the Supreme Court ruled that unless an inherited IRA is assumed, the assets aren’t protected by federal law from creditors if you declare bankruptcy.)
There are several distribution options that apply to both spouses and nonspouses, including:
Options for all beneficiaries
- Inherit the IRA. You can transfer the proceeds into an inherited IRA for your benefit so the assets can grow tax-deferred. You can then take distributions over your lifetime (even before you turn age 59½ without being subject to a 10% federal penalty) and enjoy the benefit of tax-deferred growth on the assets remaining in the account. Any distributions you take from the account will be taxed as ordinary income.
- Take a lump-sum distribution of the assets. Once you’ve inherited the IRA, you can take a lump-sum cash distribution. It’s important to know that you’ll lose the benefit of tax-deferred savings and, because the money counts as ordinary income for the year in which you receive it, you may end up with a sizable tax bill.
- Refuse to take ownership of the assets. You have the right to decline the inheritance. This refusal is called “disclaiming” or “renouncing” the inheritance. If you do, the surviving primary beneficiaries (or secondary beneficiaries if there are no other primaries) are entitled to the assets. If you’re considering this option, be sure to consult with your attorney first to determine whether this approach makes sense for you and to ensure that you’re meeting all legal requirements.
Required minimum distributions still applyIf you inherit an IRA, whether it’s a traditional or Roth, the IRS requires you to take at least some of the account balance out each year as a required minimum distribution (RMD). The amount of your first RMD—and when you need to take it to avoid tax penalties—is based on a few factors:
- Your beneficiary status: whether you’re a surviving spouse who’s the sole beneficiary, a surviving spouse who’s one of several beneficiaries, or a nonspouse beneficiary.
- The date of the original owner’s death and whether he or she reached age 70½ prior to passing. (In most cases, you’ll need to take your RMD by December 31 of the following year. However, if the owner passed after reaching age 70½, you may also be responsible for satisfying the owner’s remaining final RMD by December 31 of the year of death.)
- If other beneficiaries were named. The life expectancy used in the RMD calculation depends on whether each beneficiary has established his or her own inherited IRA by December 31 of the year following the original owner’s death. If each beneficiary has established an inherited IRA, you can use your own life expectancy to calculate your RMD. If each beneficiary hasn’t established an inherited IRA by the deadline, the oldest beneficiary’s age must be used to calculate the RMD amount for each beneficiary.
All investing is subject to risk, including the possible loss of the money you invest.
Distributions received before you’re age 59½ may not be subject to the 10% federal penalty tax if the distribution is because of your disability or death; is distributed by a reservist who was ordered or called to active duty after September 11, 2001, for more than 179 days; or is for a first-time home purchase (lifetime maximum: $10,000), postsecondary education expenses, substantially equal periodic payments taken under IRS guidelines, certain unreimbursed medical expenses, an IRS levy on the IRA, or health insurance premiums (after you’ve received at least 12 consecutive weeks of unemployment compensation).
You may wish to consult a tax advisor about your situation.