If you find yourself the beneficiary of a traditional or Roth IRA, it’s important to understand the rules that apply to these inherited IRAs. When the owner of an IRA dies, the account becomes the property of the beneficiary – or to the owner’s estate if no beneficiary was named.
The inherited IRA is not really yours
While you keep many of the IRA benefits, you are generally not considered the “owner” of an IRA when you inherit it. That is why you can’t mix inherited IRA funds with your own IRA or make 60-day rollovers to and from the inherited IRA. You also need to calculate the taxable portion of any payment from the inherited IRA separately from your own IRAs, and you need to determine the amount of any required annual minimum distributions (RMDs) from the inherited IRA separately from your own IRAs.
However, if you inherited the IRA from your spouse, you have more options. You can take ownership of the IRA funds by rolling them into your own IRA. If you’re the sole beneficiary, you can also leave the funds in the inherited IRA and treat it as your own IRA. In either case, the IRA will be yours and no longer treated as a beneficiary IRA. As the new IRA owner (as opposed to beneficiary), you won’t need to begin taking RMDs from a traditional IRA until you reach age 70½, and you won’t be forced to take RMDs from a Roth IRA during your lifetime at all. And as the IRA owner, you can also name new beneficiaries of your choice.
Required minimum distributions
As beneficiary of an inherited IRA – whether traditional or Roth – you must begin taking RMDs after the owner’s death. In general, you must take payments from the IRA annually, over your life expectancy, starting no later than December 31 of the year following the year the IRA owner died. But if you are a spousal beneficiary, you can usually delay payments until the year your spouse would have reached 70½.
In some cases, you can satisfy the RMD rules by withdrawing the entire balance of the inherited IRA by the fifth anniversary of the owner’s death. In nearly every situation, though, it makes sense to use the life expectancy method instead – to stretch payments out as long as possible and take maximum advantage of the IRA’s tax-deferral benefit.
You can elect to receive more than the required amount in any given year, but if you receive less than the required amount you’ll be subject to a federal penalty tax of 50% of the difference between the required distribution and the amount actually distributed.
More stretching for inherited IRAs …
What happens if you elect to take distributions over your life expectancy but you die with money still in the inherited IRA? This is where your IRA custodial/trustee agreement becomes crucial. If, as is sometimes the case, your IRA language doesn’t address what happens when you die, then the IRA balance is typically paid to your estate – thus ending the IRA tax deferral.
Many providers, though, allow you to name a successor beneficiary. In this case, when you die, your successor beneficiary steps into the role of owner and can continue to take RMDs over your remaining distribution schedule, maintaining the tax benefits over time.
Federal income taxes
Distributions from inherited IRAs are subject to federal income taxes, except for Roth or nondeductible contributions the owner made. But distributions are never subject to the 10% early-distribution penalty, even if you haven’t yet reached age 59½. (This is one reason why a surviving spouse may elect to remain a beneficiary rather than taking ownership.)
When you take a distribution from an inherited Roth IRA, the owner’s nontaxable Roth contributions are deemed to come out first, followed by any earnings. Earnings are tax-free if made after a five-calendar-year holding period, starting with the year the IRA owner first contributed to any Roth IRA. For example, if the IRA owner first contributed to a Roth IRA in 2014 and died in 2016, any earnings distributed from the IRA after 2018 will be tax-free. Once this five-year period is over, you are in the tax-free category.
Creditor protections for inherited IRAs
Traditional and Roth IRAs are protected under federal law if you declare bankruptcy. The IRA bankruptcy exemption was originally an inflation-adjusted $1 million, which has since grown to a total of $1,283,025. Unfortunately, the U.S. Supreme Court has ruled that inherited IRAs are not covered by this exemption. (If you inherit an IRA from your spouse and elect to treat that IRA as your own, it is possible that the IRA won’t be considered an inherited IRA for bankruptcy purposes, but this was not specifically addressed by the Court.) This means that your inherited IRA won’t receive protection under federal law if you declare bankruptcy. However, the laws of your state may still protect those assets, in full or in part, and may provide protection from creditors outside of bankruptcy as well.