IRAs are among the largest assets inherited by heirs and beneficiaries. These accounts are able to grow to very large amounts because income taxes are deferred until the owner begins to take distributions, which usually happens after the owner reaches age 70 ½.
Those who inherit an IRA must be very careful to follow the rules, which can be complicated and often confusing. It is possible to keep an account growing tax-deferred for decades, but an innocent error can cause the recipient to lose the tax-deferred advantage and force him or her to pay tax now on the entire account balance. As a result, it is critical to talk with an expert before making any decision or taking any action regarding an inherited IRA so that you can understand all available options. Here are some options to consider.
Inherited IRA Cash Out Option
Anyone who inherits an IRA can cash it out and withdraw the full amount. However, because income taxes must be paid on the full amount at one time, this is not usually the best choice. Remember, the larger the account balance, the larger the tax bill.
Spouse Options for Inherited IRAs
A surviving spouse who inherits an IRA from his/her spouse can roll it into a new IRA or merge it with his/her own existing IRA. Either way, the account can continue to grow tax-deferred and the surviving spouse can continue to make contributions until he/she must start taking required distributions after age 70 ½.
If the inherited IRA is rolled into a new IRA, the surviving spouse will name new beneficiaries. It is highly advantageous to name someone who is much younger (like children and grandchildren) because after the surviving spouse’s death, distributions will be based on the beneficiary’s actual life expectancy. This could allow the account to continue to grow tax-deferred for decades. Under IRS rules, this rollover and stretch out can be done even if the original owner spouse had started taking required minimum distributions before he/she died.
Non-Spouse Options for Inherited IRAs
If the original IRA owner died before he or she started receiving required distributions, a non-spouse beneficiary can establish a Beneficiary IRA and start taking annual distributions based on his/her own life expectancy, with the option to take a lump sum at any time. (This is called the “life expectancy option.”) This must be done by the end of the year following the original owner’s death. If the first distribution is not taken by then, the entire amount in the IRA must be withdrawn by December 31 of the fifth year after the owner’s death. (This is called the “five year rule.”)
If the original owner died after he or she started receiving received required distributions, a non-spouse beneficiary must take a distribution equal to the owner’s required minimum distribution for the year he/she died if one had not been taken. For subsequent years, distributions can be based on either the new owner’s life expectancy or the original owner’s remaining life expectancy (whichever is longer).
The original IRA owner’s name must be listed on the title, but the inheriting beneficiary will name new beneficiary(ies). A non-spouse beneficiary cannot roll an inherited IRA into his/her own IRA or make contributions to an inherited IRA, as a spouse can. But when distributions are stretched out over a longer period of time, the tax payments are also stretched out. And, by keeping more money in the IRA for as long as possible, the tax-deferred growth can be maximized – which will result in a much larger balance.