Inherited IRA: How It Works and Distribution Rules

What is an inherited IRA?

An inherited IRA, also called a beneficiary IRA, is an individual retirement account that’s opened when the account’s original owner dies. Inherited IRAs can be opened with inherited assets from traditional, Roth, SIMPLE or SEP IRAs, as well as employer-sponsored retirement plans.

A beneficiary can be anyone, either related to the original owner or not, or even an entity such as an estate or trust. There are many options for what to do with an inherited IRA, but the rules vary depending on the relationship to the original owner and their age when they died. Below, we'll detail the inherited IRA rules when the beneficiary is an individual.

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Inherited IRA rules

As an individual, the rules on what you can do with an inherited IRA depend on the type of retirement account you’re inheriting; your relationship to the original account owner; when the account owner died and their age at the time of death; and whether or not the account owner had started taking required minimum distributions (RMDs).

When it comes to withdrawing from an inherited IRA, beneficiaries can choose to withdraw all the money as a lump sum or take annual distributions over a 10-year period. Traditional IRA withdrawals are counted as income and taxed at the beneficiary’s ordinary income tax rate(s). In general, most beneficiaries must deplete the account within 10 years of the account owner’s death.

There are some exceptions to the 10-year rule:

• You inherited the IRA from your spouse.

  You have the option of taking distributions based on your life expectancy or rolling the account over into your own IRA.

• You’re a minor child.

  You can take distributions based on your life expectancy until age 21.

• You’re chronically ill or disabled.

  You can stretch the IRA distributions out over your lifetime.

• You’re not more than 10 years younger than the account owner.

  Withdrawals can be stretched over your lifetime.

If you inherited IRA assets from someone who died before Dec. 31, 2019, the 10-year rule does not apply, and withdrawals can typically be stretched over the course of your lifetime.

Inherited IRA distribution rules for spouses

If you're the sole beneficiary of your spouse’s IRA, you can take over the account. That's also known as a spousal transfer or “assuming” the IRA. By doing this, you can keep making contributions, and the schedule for required minimum distributions is reset so that it's based on your life expectancy.

As the sole beneficiary, you can move the assets into your name in a few different ways:

• You can assume ownership by designating yourself as the owner of the existing account.

• You can roll the assets from the deceased’s account into an existing IRA in your name — just make sure the inherited assets are taxed the same as the account you’re rolling into (either a traditional or Roth IRA).

• If you don’t have an existing IRA, you can set up a new account in your name to roll the inherited assets into.

• You can also take a lump-sum distribution to receive the assets as cash. However, before taking any distributions, you might want to speak with a tax professional to understand your potential tax consequences.

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Inherited IRA distribution rules for non-spouse beneficiaries

There's a bit more administrative legwork required if you’re a non-spouse inheriting an IRA or a spouse who is not the sole beneficiary.

• The IRS doesn’t allow you to roll the money from an inherited IRA into one of your existing accounts. Instead, you’ll have to transfer your portion of the assets into an inherited IRA; for example, (Name of Deceased Owner) for the benefit of (Your Name). This would allow you to stretch out RMDs over your life expectancy.

• No additional contributions are allowed in the new, inherited IRA account.

• Depending on when the account owner died, you may need to follow an RMD schedule that's based on the life expectancy of the deceased owner.

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Other inherited IRA rules

The 5-year rule for an inherited Roth IRA

Roth IRA beneficiaries can withdraw contributions tax-free at any time. Note here that we’re talking about Roth IRA

contributions

The five-year rule is critical: If the Roth IRA was less than five years old at the original owner’s death, you’ll owe taxes on the earnings you withdraw.

It’s also important to note that while the original owner of a Roth IRA does not have to take RMDs over the course of their lifetime, beneficiaries who inherit a Roth IRA do have to take an RMD to avoid penalties. The penalty for missing an RMD can be as high as 50% of the account value, so make sure you understand the RMD schedule.

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Taxes on withdrawing money from an inherited IRA

As tempting as it might be to cash out an inherited IRA (called a lump-sum distribution), tread carefully. Going this route could leave you owing a hefty sum when it’s time to file your taxes. Withdrawals from a traditional IRA are generally taxable as income at your ordinary income tax rate(s).

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