Inherited IRAs (individual retirement accounts passed on to beneficiaries following the death of the account holder) have different rules than traditional IRAs and Roth IRAs. Among the differences are the decisions that the surviving spouse and/or heirs must make about what to do with the accounts.
Surviving spouses can treat the inherited IRA as their own. This is done by creating a new IRA in the surviving spouse’s name. Those who choose this option take ownership of the traditional or Roth IRA. Importantly, the required minimum distributions (RMDs) for traditional IRAs are treated as if the surviving spouse were the owner starting with the year he or she elects to be or is deemed the owner. Similarly, the inherited IRA can be rolled into an existing traditional IRA or into a workplace retirement plan [e.g., a 401(k) plan], if permitted.
Two other options exist. Surviving spouses can treat themselves as beneficiaries. This involves transferring the assets into an inherited IRA. Depending on whether or not the decedent reached age 70½, distributions can be taken based on the deceased’s life expectancy, the surviving spouse’s expectancy or over a five-year period. A lump-sum distribution can also be taken.
Non-spouse beneficiaries have fewer options. Specifically, they cannot treat the inherited IRA as their own. Rather required minimum distributions are mandatory for both traditional and Roth IRAs. These distributions must start no later than December 31 of the year following the passing of the deceased or over a five-year period. Alternatively, a lump-sum distribution can be taken. (In situations where more than one beneficiary inherits the IRA, it’s prudent to establish separate accounts for each beneficiary.)
Both spousal and non-spousal beneficiaries have the option of disclaiming or renouncing the inheritance.
From a tax perspective, Roth IRA earnings are taxable for both spouses treating themselves as beneficiaries and non-spouse beneficiaries if the account is less than five years old when the account owner passed and distributions are taken before the spouse/beneficiary reaches age 59½. Furthermore, distributions from an inherited traditional IRA are generally taxable. Both can push the beneficiary into a higher tax bracket. The 10% early penalty for IRA withdrawals does not apply to inherited IRAs.
Source: “Inherited IRAs—What You Need to Know,” FINRA Investors Alerts, January 3, 2017.
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