How to Handle Inheriting an IRA

If you inherit a traditional IRA, there may be tax implications to consider.  Tax rules differ depending on whether or not the beneficiary is a spouse. Knowing the rules can shield you from some serious tax consequences.

If you’re a spouse of the deceased, you have a number of scenarios, depending on your age. One option, that is perhaps the simplest option, is for the surviving spouse to roll it over into his or her own IRA or a newly established IRA.

However, there are different rules if someone else, like a child, inherits a traditional IRA. In that case, your two potential choices are:

• Sell the assets and take a lump sum withdrawal. You will have to pay tax as if it were ordinary income. Based on your bracket, that could mean the government gets a big slice of the pie.
• Keep the account invested in a new “inherited IRA” account. It will continue to grow tax-free, but you have to make minimum withdrawals. The passing of the SECURE Act in January 2020 changed how these IRAs are distributed.  Those who inherited an IRA after January 1, 2020, must take the full amount out within 10 years (in most situations.) Those who inherited an IRA before 2020 can continue to stretch it for the predicted length of their own lives, allowing the funds to grow tax free in the meantime

It is important to note that taxes must be paid on withdrawals from the IRA because the money counts as income and thus, is taxed as such. Work with your financial planner to discuss taking out additional money to cover taxes if you would rather pay tax upon withdrawal and not get hit with a larger tax bill during tax season.

Different Rules for Roth IRAs

With a Roth IRA, the money went into the account after taxes, so the scenarios are somewhat different. When spouses inherit, they again have the option of rolling it over into their own new IRA. Also, they can take a lump-sum distribution, but they should keep an eye on the calendar; the earnings will be taxable if the account is less than five years old.

Those who are not spouses have a better deal with a Roth than with a traditional IRA. A lump sum is still an option, although they likely will still be on the hook for taxes on the dividends, interest, and realized capital gains earned on funds withdrawn from an inherited Roth IRA.

These are just the basics, and there may be other options, or situations that impact your choices. There are also modifications to these rules if an IRA has been left to be divided among multiple heirs. The key takeaway here is to not make any immediate decisions after inheriting an IRA but to consult with a financial professional about what the best move is in your situation.

Making the Future Easier

As for any IRAs you have now, make sure your beneficiary designations are up to date.  It’s a common misconception that a will can override an IRA designation. It doesn’t. This causes problems when the beneficiary is deceased, the IRA is left to an ex-spouse instead of the current spouse, or the beneficiary defaults to the decedent’s estate.