What Happens if You Inherit an IRA?

By Christy Bieber Markets Fool.com

The death of a loved one is always a tragedy. Unfortunately, in your time of grief, your struggles to cope with your loss may be compounded by the legal complexities of an inheritance.

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There are many rules when it comes to property passed to you after a death, including very specific requirements for inherited IRAs.

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Why does an inherited IRA have special rules?

If you inherit an IRA, or individual retirement account, you may have a limited time to decide what to do with it.Making a decision requires understanding IRS rules, which vary based on the type of IRA, your relationship to the deceased account holder, and the age of the account holder.

You must make a timely decision because the IRS generally -- but not always -- mandates required minimum distributions (RMDs)from inherited IRAs. That means you must start withdrawing a set amount of money from the account at periodic intervals.

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If you do not take RMDs, you face a 50% tax penalty on the money you should have withdrawn.You could lose 50% of your money to the IRS if you don't act!

This doesn't mean you should withdraw all assets from inherited IRAs. Money is taxed when taken out of a traditional IRA; if you expect to be in a lower tax bracket by the time RMDs are required, you can leave the funds in the account until you must begin withdrawals and thereby avoid paying your current higher rate on IRA assets.If you inherit a Roth IRA, leaving assets in the account as long as you can has an even bigger benefit: You can continue to allow the assets to grow tax-free. If you leave assets in the Roth IRA, you won't be taxed on gains, no matter how much the account grows.

This guide explains your options when you inherit an IRA under various circumstances.

If you inherit a traditional IRA from your spouse

If your spouse had a traditional IRA and passed away prior to age 70-1/2, you have three options. As you consider them, remember that you're always taxed on distributions from these accounts.

  • You can transfer the assets into your own IRA:As long as you were the sole beneficiary of your deceased spouse's IRA, this option may be the easiest. The assets are treated as if they'd been yours all along and your age determines your RMDs. The downside: You'll face an early-withdrawal penalty if you take out money before 59-1/2.
  • You can transfer the assets into an inherited IRA:The inherited IRA is held in your name, but unlike when you treat the IRA as if it were your own, you don't have to wait until you're 59-1/2 to start taking money out without penalty. You can choose one of two options for withdrawals of a inherited IRA. A five-year option allows you to take assets out immediately, but requires you to take out all of the assets within five years of the death.The life expectancy option spreads out distributions based on life expectancy,determined by your age and reevaluated annually, as outlined inIRS Publication 590-B. Distributions must begin before the end of the year in which the original account-holder would have turned 70-1/2.
  • You can take all of the assets out of the IRA:If you take a lump sum distribution, you take all of the assets out at once. You will have to pay income tax on the entire distribution in the tax year it's made.

If your spouse was over 70-1/2 at the time of their death, you may still move assets into your own IRA or take a lump sum distribution as outlined above. However, the rules differ for the other options. If you move the assets to an inherited IRA, then your distributions must be calculated based on your life expectancy or the original IRA owner's age. RMDs must start by the end of the year after death; however, if your deceased spouse didn't take his or her RMD before death, you must take the distribution in the same year the death occurred.

If you inherit a Roth IRA from your spouse

When you inherit a Roth IRA from your spouse, you have the same basic options as with a traditional IRA, but the rules differ slightly. And as long as you follow the rules, you won't be taxed on withdrawals at all.

  • You can transfer assets into your own Roth IRA:The assets are treated as if they were yours, and you do not have to take RMDs. This is the big exception to the rule that inherited IRAs come with RMDs.
  • You can open an inherited IRA:You may use the five-year option and complete all distributions within five years of the original owner's death. You can also use the life expectancy option, but you must start taking distributions by the later of 1) the end of the year after death or 2) the date when your spouse would have reached age 70-1/2.
  • You can take a lump sum distribution.Unlike with a traditional IRA, you won't be taxed. However, you'll lose the chance for continued tax-free growth.

One caveat: To benefit from tax-free distributions, a Roth IRA must have been open at least five years. If the account was open less than five years, then you could be taxed on any earnings upon distribution.

If you inherit any IRA from someone other than your spouse

When you inherit a traditional or Roth IRA from anyone who is not your spouse, you are not allowed to roll the account over into your own IRA. Lump sum distributions are allowed, or you can open an inherited IRA.

Both the five-year option and life expectancy option are available to you, but you must act quickly to use the life expectancy option, because you must begin making distributions by the end of the year after the account holder's death for both Roth and traditional IRAs.

It's hard to think about finances after the death of a loved one, but avoiding the tax penalties is vital to protect the inheritance you've received. Review your options carefully and talk with a tax professional if you've inherited a substantial IRA and cannot decide which option is best.

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