5 Things You Really Need to Know about Your Inherited IRA

 In Retirement

inherited ira

When most of us think about IRAs, we picture accounts we open ourselves in order to save for retirement.

However, there is such a thing as an inherited IRA, and if you are the inheritor of one of these accounts, you need to know several key things to make sure you’re using them correctly.

As Deborah L. Jacobs states in her article for Forbes, “Whether you’re inheriting an IRA or aiming to protect your own heirs, you’ve got to dance the IRS jig.”

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What Is an Inherited IRA?

An inherited IRA is nothing more than an individual retirement account opened by someone else, and then passed to an heir upon that person’s death.

It could be an IRA opened by a parent passing to one of their children. It could be an IRA opened by a spouse, passing to the other spouse.

However, don’t let that seeming simplicity fool you. It’s actually a complicated situation. Here’s what you need to know about handling your inherited IRA.

Only Beneficiary Spouses Can Roll an Inherited IRA Over

You might think that upon inheriting an IRA, you could just roll it over into your own individual retirement account, but that would be wrong. The government doesn’t allow that, unless you’re an inheriting spouse. Any other heir, including children of a parent, cannot roll the IRA into their own account.

With that being said, if you’re a widow or widower inheriting the IRA of your spouse, you are allowed to roll that account into your own without any legal repercussions (other than paying the eventual tax on that account in the case of a standard, non-Roth IRA).

Often, this is the simplest solution for spouses, and can greatly aid in your own retirement planning. However, if you’re not a surviving spouse, you’ll need to take another action.

A lot of this is because you’re legally required to start taking withdrawals from the IRA unless you’re a surviving spouse – you can’t leave the money in the account.

As a note, if the account in question is a Roth IRA, and the surviving spouse (you) decides to take disbursements early, you will face the 10% penalty, which could eat into your nest egg considerably. This only applies if you have not yet reached 59.5 years of age, of course.

You Can Opt for a Lump Sum Payment

Any heir inheriting an IRA, including spouses, can opt to take a lump sum payment from the account. Essentially, this will close out the account.

The IRS will take their cut of the pie, and you’ll lose some benefits (such as the ability to generate tax-free income down the road with a Roth IRA).

If the amount in the IRA isn’t all that significant, this may be the simplest option for non-spousal heirs, and you don’t have to worry about the 59.5-year-old rule, either.

You can take a lump sum withdrawal from an inherited IRA at any age. However, if the amount in the account is significant, you might be better served by changing tactics and going a different route. This is also where things get a bit more complicated.

retirement accounts 401K IRA

Using the Stretch Rule

There’s such a thing as the “stretch rule” that applies to an inherited IRA. In this instance, you would begin taking disbursements every year.

There are two factors that will determine the amount of each withdrawal. The first of those is your life expectancy at the time of the original IRA owner’s death. The second is the total value of the money in the account. The IRS actually has a chart that you will use to determine this.

You’ll use that number to determine the percentage of the account’s value you’ll take out annually. For instance, if your life expectancy is another 36 years, then you would be legally required to take 1/36 of the account’s value out the first year. The next year that would drop to 1/35 and so on.

Note that this is the only way that you can maximize your tax benefits with an inherited IRA. It’s also possible to leave the money in the account for a very, very long time (decades in some instances) during which time it will grow significantly (and still enjoy tax advantages).

The Five Year Rule

There’s another rule that applies to an inherited IRA. The five-year rule is essentially this: if the owner of the IRA had not yet started taking disbursements from the account, you are legally allowed to leave the money in the account for another five years (at maximum – you can withdraw it before that if you prefer, but you cannot leave it for longer than five years).

Once you reach the five-year mark, the entire amount in the IRA has to be withdrawn. Why wait if you have to withdraw the entire amount eventually? It’s all about buying time. You can figure out how to protect yourself from the additional tax liability during that time.

Know Your Restrictions

While an inherited IRA can be a blessing, there are quite a few things that you’re not allowed to do. For instance, you can’t convert it into a Roth IRA. That does not apply to surviving spouses, though, only other heirs.

In the end, an inherited IRA can be a significant financial windfall, but it needs to be utilized correctly. Unless you’re a surviving spouse, there are considerable restrictions on what you can and cannot do with that account.

A wrong move could leave you facing serious tax penalties, so it’s best to plan carefully before taking any action.

happy retirement

Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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