If you inherit an IRA, you need to understand your options to maximize its value and avoid unnecessary taxes

What To Do If You Inherit an IRA

Traditional IRAs were established in the U.S. by the Employee Retirement Income Security Act of 1974 (ERISA) and became effective in 1975 with an initial annual contribution limit of $1,500 or 15% of wages/salaries/tips. Today, an estimated $5 trillion dollars are held in IRAs and these accounts are showing up more frequently as inheritances.
The ownership of an inherited IRA depends upon the beneficiary designation established by the original account holder. This designation trumps any distribution of assets in the will.
If you inherit an IRA, you have a number of options:
A spouse beneficiary of an IRA can:

  1. Roll over the IRA to a new IRA that is in his or her own name. This allows beneficiaries and the required minimum distribution schedule to be reset and is typically the most flexible approach.
  2. Transfer the IRA to an inherited IRA, held in the name of the original account holder and follow the distribution requirements outlined below.
  3. Cash out the IRA through either a lump sum distribution or allocated over five years, paying income taxes as distributions are made.

Non-spouse beneficiaries have two choices:

  1. Cash out the IRA through a lump-sum distribution or over a period of five years.
  2. Transfer to an “inherited” IRA held in the name of the original account holder for the heir’s benefit.

With a lump-sum distribution, income taxes are paid all at once, however, there is no 10% early withdrawal penalty. The lump-sum distribution counts as income on the individual’s tax return and may bump the heir into a higher tax bracket. A better alternative may be to make distributions over a five-year period to minimize the impact on the individual’s tax bracket.
Transferring to an inherited IRA allows the beneficiary to receive distributions over a longer period of time, stretching out the taxation of distributions. The stretch period will depend on the age of the original IRA holder. If the account holder was under age 70½, the minimum required distribution is calculated based on the heir’s expected lifetime and must start no later than December 31 following the year of the original account holder’s death.
If account holder was over age 70½ at the time of death, the heir’s options include cashing out the account or annual distributions spread over the longer of the original account holder's or the heir’s expected lifetime, beginning no later than December 31 following the original account holder's death. (If the original account holder did not take an RMD in the year he or she died, the heir must take the distribution by the end of that year.)
What you do not want to do is to transfer or rollover the inherited IRA to an IRA in your name. That counts as a lump-sum distribution, triggering taxes on the full balance. An “inherited” IRA does not need to stay with the original custodian, but may be established at a custodian of your choice.
For more information on how to best manage an inherited IRA, contact our office and we will review your options and how your inheritance can best work to your advantage.