What to Do with an Inherited IRA
Individual Retirement Accounts (IRAs) are among the largest assets inherited by heirs and beneficiaries. These accounts are able to grow so large because income taxes are deferred until the owner begins to take distributions, usually after reaching age seventy-two.
Those who inherit an IRA must be very careful to follow the rules, which are complicated and often confusing. It is possible to keep an inherited account growing tax-deferred for decades in some cases, and for up to ten years in others, but an innocent error can cause the recipient to lose the tax-deferred advantage and force the recipient to pay taxes now on the entire account balance. As a result, it is critical to talk with an expert to understand all available options before making any decision or taking any action. Here are three options to consider:
Cash-Out Option
Anyone who inherits an IRA can cash it out and withdraw the full amount. Because income taxes must be paid on the full amount at one time, however, this is not usually the best choice.
Spouse Options
A surviving spouse who inherits an IRA from a deceased spouse can roll it into a new IRA or merge it with the surviving spouse’s own IRA. In either case, the account can continue to grow tax-deferred, and the surviving spouse can continue to make contributions until he or she must start taking required distributions (after age seventy-two). If it is rolled into a new IRA, the surviving spouse will name new beneficiaries.
Nonspouse Options
Nonspouse beneficiaries can establish a beneficiary IRA. The entirety of the IRA must be withdrawn by the end of the calendar year that includes the tenth anniversary of the original owner’s death (the ten-year rule), unless the nonspouse beneficiary qualifies as an eligible designated beneficiary (EDB). EDBs including the following types of beneficiaries:
- surviving spouse of an account owner
- person who is not more than ten years younger than the account owner
- minor child of the account owner
- disabled person
- chronically ill person
An EDB may generally withdraw distributions based on the EDB’s life expectancy, allowing the account to continue to grow tax-deferred (called “stretch” treatment). The original owner’s name must be listed on the title, but the inheriting beneficiary will name new beneficiaries. A nonspouse beneficiary cannot roll an inherited IRA into the beneficiary’s own IRA or make contributions to an inherited IRA as a spouse can. But when distributions are stretched out over a longer period of time, the tax payments are also stretched out. Further, keeping more money in the IRA for as long as possible maximizes the tax-deferred growth, which will result in a much larger balance.
Conclusion
The identity of the beneficiary controls the distribution period of an IRA inherited from a deceased owner. But anytime you name an individual as beneficiary, you lose control. After you pass away, the beneficiary can do anything the beneficiary wants with the account, and the money can also be available to the beneficiary’s creditors, spouse, and former spouses. If the beneficiary is eligible for government benefits, leaving money outright to the beneficiary could disqualify the beneficiary from receiving those benefits. There is also the risk of court involvement if the beneficiary becomes incapacitated. Naming a trust as beneficiary will give you more control over your IRA in these circumstances, but the rules regarding inherited IRAs and trusts are complex. Make sure you consult an experienced estate planning attorney to discuss these important issues and make the best plan for you and your family.