What To Do When You Inherit An IRA

What to do with an inherited IRA

What to do with an inherited IRA

There’s nothing really cool about inheriting an IRA. Someone had to die! And if you’re the beneficiary, it was probably someone very close to you.

So your first responsibility… take all the time you need. Mourn, remember, reflect. Do what you need to do. Talk about what made that person so great, and why you kept them in your life.

At the right time, the dust will settle, and it will be time to address the finances. If you are the beneficiary of an IRA, it’s important to know what options you have.

Your options will depend on your relationship to the deceased. There are different rules for spouse and non-spouse beneficiaries.

For A Spouse

As a spouse, you have a few options available when you inherit an IRA:

Option 1 – Cash it out

You can cash out the IRA.  The IRS loves when you do this!  And why?  Because they collect taxes.  All the money you withdrawal will be taxed as ordinary income.  The bigger the IRA, the bigger your income, the bigger the tax hit is likely to be.   This probably isn’t your best option.

Option 2 – Make it your own IRA

This seems easy.  Make the IRA your own, and go on your way.  You can even combine this with other IRA’s (if you have them).  But you’ll want to understand all your options before making this decision.  Because once a decision is made, there is no going back.

Option 3 – Make it an inherited IRA

Choosing to make an IRA an inherited IRA can provide you additional flexibility.  What does this mean?  With an inherited IRA, you may be able to access your money penalty free prior to age 59.5 (something you cannot do with your own IRA).  You can also delay taking required minimum distributions (RMD’s) until the deceased would have been 70.5 years old (benefiting from continued tax deferral).

Specifically, you may want to consider an inherited IRA if you fall into one of the following scenarios:

  1. You are under 59.5 years old, and need access to the money sooner rather than later.
  2. You are older than your deceased spouse and are looking to delay RMD’s as long as possible.

Making it an inherited IRA isn’t all good though, the Supreme Court recently ruled that inherited IRA’s are not protected from bankruptcy.

Option 4 – Make it a ROTH IRA

I love ROTH IRA’s (but that doesn’t mean they are for everyone).  Tax free money, tax deferred growth, no RMD.  All good things if used appropriately!  The longer you have a ROTH IRA, the better it tends to get.

Why?  Because the money can be invested.  And all the growth you earn will be tax-free (as long as the funds have been invested at least 5 years)!  The more growth, the more tax-free money you have.

But keep in mind, investing does carry with it risk that your account can go down in value (buzzkill!).  Also important, in the year you convert your IRA into a ROTH IRA, you are going to pay taxes.  Potentially a lot in taxes.  The IRS will tax you on the amount you convert as ordinary income (ask your accountant!).

Bottom line – ROTH conversions make sense if you don’t need the money for the foreseeable future.

How long?  Well, that depends on a lot of factors.*

Option 5 – Disclaim the IRA

You always have the option to say I don’t want it.  But let’s be honest, how many times are people going to do this?

For A Non-Spouse Beneficiary

Options for a non-spouse beneficiary are similar.  The biggest differences are:

  1. You cannot make it your own IRA.
  2. The rules for an inherited IRA are different.

Option 1 – Cash it out

Do you already have the brand new car you don’t need picked out?  Finally have some extra cash to make the purchase…. Well slow down!  Take your foot off the gas (sweet pun right!).  You’ve just inherited a lot of money, don’t jump into a big decision you get can’t get out of.

If you cash out the IRA, you will be required to claim all the income on your tax return in the year of distribution.   If we assume a large distribution and a high tax bracket, you might be waving goodbye to nearly half of the IRA to taxes.  Proceed with caution!

Option 2 – Make it an inherited IRA

This is often the best option for many of my clients who inherit an IRA.  You continue to reap the benefits of tax deferral!  However, the IRS does require you to start taking RMD’s, most times based on your own life expectancy (which often times isn’t that big of a deal).  The younger you are, the less you are required to take out.

The first distribution is required to be taken out by the December 31st, the year following the year of death.  If you miss your required distribution, the penalty is severe –  50% of what you should have taken out!

Option 3 – Disclaim the IRA

Just like above, you always have the option to say “I don’t want it.” But let’s be honest, how many times are people going to do this?


Required Disclosure

*To achieve completely tax-free status in a ROTH IRA, you will need to defer taking any distributions from you ROTH IRA until at least age 59.5, the original funds must have been invested for at least 5 years, or some other exception applies.  Absent any exceptional circumstances, withdrawing money from a ROTH IRA early incurs not only taxes on the earning, but also a ten percent penalty.

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2 Responses to What To Do When You Inherit An IRA

  1. Gregory A. Baroni August 14, 2014 at 1:36 pm #

    Dan, you have put together some nice info here. Here are some things for IRA owners to consider when planning to transfer the IRA upon death:

    Using a trust as beneficiary of an IRA or retirement plan account will let you use the oldest beneficiary’s life expectancy to stretch out the tax-deferred growth. It will let you keep control over when the beneficiary receives distributions, and can protect the asset from the beneficiary’s creditors (including bankruptcy), predators (those who may have undue influence on the beneficiary), irresponsible spending, and divorce proceedings. You can even provide for a beneficiary with special needs without jeopardizing government benefits.

    Many people opt for a separate share for each beneficiary or even a separate trust for each beneficiary. These are called “stand alone retirement trusts” because they are created solely for retirement plan and IRA assets.

    • Daniel Zajac, CFP®, AIF®, CLU® August 15, 2014 at 8:33 am #

      Greg, thanks for the comment. There are certainly planning opportunities available when naming beneficiaries for IRA/401k accounts. It’s important to understand what goals and objectives the client is looking to achieve. Then its easy to educate the client on the pro’s and con’s of each option.

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