Receiving an inheritance can be a blessing, but there are typically tax obligations involved including the inheritance of an IRA. If you inherit an IRA, you should check with an attorney or financial advisor as soon as possible to find out what your options are.
IRAs are personal savings plans that allow you to set aside money for retirement while getting a tax deduction. There are two ways to get the deduction:
Traditional IRAs: Earnings generally are not taxed until distributed to you. At age 70 1/2 you have to start taking distributions from a traditional IRA.
Roth IRAs: earnings are not taxed, nor do you have to start taking distributions at any point, but contributions to a Roth IRA are not tax deductible. Any amount remaining in an IRA upon death can be paid to a beneficiary or beneficiaries.
When the beneficiary is a spouse
If you inherit your spouse’s IRA, you can treat the IRA as your own. You can either put the IRA in your name or roll it over into a new IRA. The Internal Revenue Service will treat the IRA as if you have always owned it.
If you are not yet 70 ½ years old, you can wait until you reach that age to begin taking minimum withdrawals. If you are over 70 ½ and were 10 or more years younger than your spouse, you can use a longer joint-life expectancy table to calculate withdrawals, which means lower minimum withdrawal amounts.
If you inherit a Roth IRA, you do not need to take any distributions. You can leave the account in your spouse’s name, but in that case you will need to begin taking withdrawals when your spouse would have turned 70 ½ or, if your spouse was already 70 ½, then a year after his or her death.
If you want to drain the account, you can use the “five-year rule.” This allows you to do whatever you want with the account, but you must completely empty the account (and pay the taxes) by the end of the fifth year after your spouse’s death.
When the beneficiary is not a spouse
The rules for any non-spouse who inherits an IRA are somewhat different than those for a spouse. There are two options to choose from:
1. The Stretch Option
You can choose to take distributions over your lifetime and pass the remainder onto future generations. The required minimum distributions will be calculated based on your life expectancy. This allows the money to grow tax-deferred over the course of your life and then passed on to your beneficiaries. If you want to do this, you must retitle the IRA into an inherited IRA and take your first distribution by December 31 of the calendar year following the year the decedent died.
2. Complete Distribution
If you choose not to stretch the IRA, you will have to withdraw the entire account within five years of the original IRA owner’s death. This can lead to a large tax bill–unless the IRA is a Roth, in which case the distributions are tax-free.
Trust as beneficiary
If the IRA names a trust as the beneficiary, the trust may not be able to take advantage of the opportunity to stretch withdrawals across decades. If the trust is considered “see-through” or a conduit trust, then stretching an IRA may still be an option. If you have inherited an IRA in a trust, it is best to contact your attorney to find out your options.
If the decedent’s estate was subject to an estate tax, the IRA beneficiary may be able to get an income tax deduction for the estate taxes paid on the IRA.