What to do with an inherited IRA: The most common scenarios

If you have a loved one who recently passed away and left you their retirement savings, you may be wondering what to do with an inherited IRA. Should You Cash Out an Inherited IRA or Top Up Your Balance?

The answer is complicated. They exist other rules guidance on what you can do with an inherited IRA based on the type of IRA, your loved one’s age when they died, and your relationship with them. Because an IRA is a tax-advantaged account, these rules are set by the IRS.

Below are the options available to you and other issues worth considering.

What is an inherited IRA?

An inherited IRA is a retirement account passed to a beneficiary when someone dies. For this reason, inherited IRAs are often called beneficiary IRAs.

None type IRA can be inherited, including Roth IRAs, traditional IRAs, SEP IRAs, etc. Each of these accounts can be inherited by one or more beneficiaries.

An inherited IRA

Who Can Inherit an IRA?

Anyone can inherit an IRA. The most common beneficiary is a spouse, but the person who owns the IRA can make anyone the beneficiary. This includes a child, distant relative, friend or entity (ie a trust).

If the decedent has not designated a beneficiary, the inheritance laws of your state will determine the inheritance. This can often result in multiple people inheriting one account. For example, three children could be equal beneficiaries of a deceased parent’s IRA.

📚 More information: Planning for the future means understanding all outcomes; dive into the details of our guide what happens to your 401(k) when you die.

What to do with an inherited IRA as a spouse

As the spouse of the deceased, you have several other options for what you can do with the inherited IRA. Here are the 4 main ones.

1. Transfer the IRA to your name (or move it)

When considering what to do with an inherited IRA as a spouse, you have a unique option: treat the inherited IRA as your own. This means you can either start a new IRA in your name using its funds, or roll over an inherited IRA into an existing IRA account you already have.

IRAs must be converted to IRAs of the same type, i.e. Traditional IRA to Traditional IRA or Roth IRA to Roth IRA.

This solution can help you avoid paying taxes on the inherited account until you start taking payouts when you reach retirement age.

There are two rules for this option:

  1. You must be the sole beneficiary.
  2. At the time of death, your spouse did not have to take RMDs (required minimum distributions).

⚠️ Warning: If your spouse was required to take an RMD in the year he died, you will need to make a withdrawal in that amount. If you are under 59 ½, this will result in a 10% early withdrawal penalty.

2. Open an inherited IRA

Navigating what to do with an inherited IRA can often present different paths, each offering unique financial implications. Opening an inherited IRA is a great option because it gives you more flexibility in when and how you want to receive payments. There are 3 main options:

  1. Start receiving payments over 10 years.
  2. Get paid on your own time life expectancy.
  3. Wait until your deceased spouse is no longer required to receive payments (age 73).

There are quite a few taxes and budgeting benefits with these options.

Pick #1 allows you to start taking money now and spread the tax hit over 10 years.

Compared, pick #3 can help you delay paying taxes until you are required to take payments in the year your deceased spouse would have turned 73. This can be especially helpful if your spouse was younger than you.

👉 Note: If your spouse reached the RMD age when they died, the only option available to open an inherited IRA is #2.

3. Convert to a Roth IRA

If you’re wondering what to do with an inherited IRA and expect to be in a higher tax bracket when you retire compared to now, then converting an inherited IRA to a Roth IRA could be a good solution.

To do this, you must first put the IRA in your name (the IRA rollover option). Then you can convert a traditional IRA to a Roth IRA.

You will have to pay taxes on any amount you transfer, but there is no penalty for early withdrawals. The potentially hefty tax bill is why it’s better to only transfer if you expect to be in a higher tax bracket when you withdraw.

📚 More information: Thinking about converting to a Roth IRA? Get an overview of the potential tax costs of Roth IRA conversions from our recent post.

4. Payment of lump sum

If you want to have access to all the money right away, you can get a lump sum payout. Money withdrawn from an IRA will count as taxable income for the year you make the withdrawal.

It’s also worth noting that since this is a legacy retirement account, there is no early withdrawal penalty.

Taking a lump sum payment may be the best option when you’re wondering what to do with an inherited IRA if the account value is small or you really need access to cash. If you just need a little cash right now, a 10-year repayment plan may be the best option.

What to do with an inherited IRA as a non-marital partner

Not sure what to do with an inherited IRA as a non-marital beneficiary such as a child, sibling, friend, etc.? Your options for using an inherited IRA are more limited. Here are 3 main options:

1. 10-year repayment

When you inherit an IRA, the IRS offers a 10-year payout plan. This allows you to withdraw funds from the IRA for 10 years. You can draw the money every year or let it grow tax-deferred and then withdraw it all in year 10.

To do this, you will need to transfer the funds from the IRA to an inherited IRA account in your name. Payouts will come from this new account. If you are one of several beneficiaries, you will want to separate your portion into your own account.

A 10-year payout option may be best if you want to give the money a chance to grow tax-deferred or spread the tax bill over 10 years.

2. Payment of a lump sum

You can always take a lump sum payment whenever you inherit an IRA. And because it’s an inherited IRA, there’s no early withdrawal penalty regardless of your age.

A lump sum payment may be the best option when considering what to do with an inherited IRA if there are multiple beneficiaries and/or a small IRA balance. Just be aware that money can affect your taxes, especially if it increases your tax bracket for the year.

3. Stretch the IRA

When wondering what to do with an inherited IRA, another good option is a stretch IRA. This option allows you to spread the payout payments over your lifetime. However, since the passage of the SECURE Act, the use of this type of IRA has been very limited. The only beneficiaries who can use this IRA method are:

  • Minor children
  • Persons with disabilities
  • Chronically ill individuals
  • Persons under 10 years of age of the deceased (i.e. sibling)

These individuals can choose to receive payments based on their own life expectancy or the life expectancy of the deceased. If the deceased has already reached the RMD age, you must make payments based on life expectancy.

Waiver of an Inherited IRA

Eligible spouses and non-spouses alike have one last option for dealing with inherited IRAs: disowning them. Renunciation means that you are rejecting the inheritance. You can disclaim all or part of your IRA inheritance.

If you are the sole beneficiary, the alternate beneficiary will then inherit the account. If there is no successor, the next person in line will inherit the account according to your state’s estate laws.

If you were one of multiple beneficiaries, your share of the inherited IRA will be divided among the remaining beneficiaries.

This strategy can be beneficial if you want to avoid tax consequences entirely, or if you feel that another beneficiary might benefit more from an inherited IRA.

For example, if you are a spouse and the other beneficiary is your minor child, you can disclaim the IRA. Your child could then choose to use the stretch IRA method, which will provide them with income for many years.

Other Inherited IRA Aspects

Here are some other points to consider when you inherit an IRA.

How much will I be taxed?

This depends on how and when you make payments.

All withdrawals are taxable income (except for certain Roth IRA withdrawals). The more you withdraw in a year, the higher your tax bill will be.

Imagine inheriting a $1 million traditional IRA. If you take that as a lump sum payment, you’ll owe $328,163 in federal income taxes.

In contrast, if you choose the 10-year repayment option, you will owe $14,768 per year. A total of $147,680, or almost half of the flat tax amount.

The above scenario uses a flat tax rate for 2022-2023 with no additional income and no state taxes.

The good news is that there is no early withdrawal penalty. The exception would be if you are a spousal beneficiary who rolls over an inherited IRA into your own name. If you then withdraw from the IRA before you reach 59 ½, you will face a 10% early withdrawal penalty.

📚 More information: Simplify your tax knowledge with our post that breaks down the basics “how taxes work” for individuals.

Are Roth IRAs different?

If the IRA you inherited was a Roth IRA, you can avoid paying taxes. Contributions to an IRA are made on an after-tax basis. This means they can be withdrawn tax and penalty free because the money in them has already been taxed.

Interest income is treated a little differently.

If the Roth IRA was more than 5 years old at the time of the original owner’s death, you can withdraw the earnings from the inherited IRA tax-free. For junior accounts under 5 years, the earnings withdrawal will be taxed as regular income.

If you are a spousal beneficiary, you can roll over an inherited Roth IRA into your own Roth IRA.

Are Inherited IRAs Protected During Bankruptcy?

Unlike regular IRAs, inherited IRAs are not protected when you file for bankruptcy.

This means that creditors can go after money held in an inherited IRA.

If you are a spouse beneficiary, the rules are a little different. Transferring an IRA into your name means you are fully protected during bankruptcy. However, if you keep the funds in an inherited IRA, those funds may not be safe.

📚 More information: For clarity on the types of bankruptcy, our recent post breaks down the nuances between them Chapter 7 Vs. Chapter 13.

What did the SECURE Act change?

Tea SECURE Act have made changes to how inherited IRAs can be cashed out. These changes came into force for those who died from 2020 onwards.

If your loved one passed before 2020, then the rules for transferring and using inherited IRA funds are slightly different. Here are the key differences.

  • There was a 5 year option, not a 10 year option
  • Non-spousal beneficiaries had the option to roll over an IRA
  • Use of the 5-year plan was much more limited than the new 10-year plan
  • The RMD age was previously 72

For more details on how IRA inheritance is affected by death before 2020, see IRS payee page.

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