Though most people open individual retirement accounts (IRAs) on their own to save for retirement, it's possible to inherit an IRA, too.
What Is an Inherited IRA?
As the name implies, an inherited IRA is a retirement account that someone leaves to a loved one when they die.
People who inherit an IRA are typically separated into two categories: spousal beneficiaries and nonspousal beneficiaries. Each category follows different rules around withdrawing from an IRA.
Rules for Spousal Beneficiaries
If you inherit an IRA from your spouse, you have more options for handling it than a nonspousal beneficiary.
You could transfer what's in the account to an existing IRA or a 401(k) plan or open a new IRA. Once you do, you can make penalty-free (but not tax-free) withdrawals once you turn 59 1/2. You can make withdrawals before then, but you'll pay a 10% early withdrawal penalty on top of income tax on what you withdraw.
You don't have to make withdrawals right away, even if you're over 59 1/2. The money in an inherited account grows tax-deferred if you inherited a traditional IRA, as it's funded by pretax income.
As the spousal beneficiary, you can put the inherited account in your name. You'd be listed as the account holder, and the IRS would treat you as if you were the original account holder. You could also leave yourself as the beneficiary and take distributions or withdrawals from the account.
Many of the rules for spousal beneficiaries also apply to other eligible designated beneficiaries, such as minor children, disabled or chronically ill beneficiaries, and beneficiaries who are 10 years younger than the account holder. If you are in one of these categories, you'll also have more flexibility in managing the account than if you were a nonspousal beneficiary.
Required Minimum Distributions
When you inherit an IRA as a spousal beneficiary, you'll have to consider required minimum distributions. This is a specified amount that must be withdrawn from the account each year, once you hit a certain age, so the federal government can collect income tax on it. The SECURE Act raised the required minimum distribution age from 70 1/2 to 72.
This could affect how and when you make withdrawals. If your spouse had started taking required distributions, you can continue taking them or create a new distribution schedule based on your life expectancy. If your spouse hadn't started taking distributions, you must start taking distributions by the end of the year your spouse would have been eligible to start taking them.
Rules for Nonspousal Beneficiaries
If you don't classify as a spousal beneficiary, the rules are more complex.
If you're a nonspousal beneficiary, you can withdraw all the money from the account you inherit as a lump-sum distribution. However, you could accrue with a hefty tax bill; you'll have to pay taxes on the distribution based on your income tax rate.
Another option is to open a new inherited IRA. (It's also called a stretch IRA.) Before 2020, nonspousal beneficiaries could stretch taxable distributions over their life expectancy. The old rules let younger beneficiaries take distributions — and avoid income taxes on them — longer.
The SECURE Act changed things. Now, most nonspousal beneficiaries must empty an inherited IRA within 10 years. If you don't, you'll face a 50% tax penalty on whatever's left in the account.
These new rules could have significant tax implications if you're in a high tax bracket and must take withdrawals. Consider taking higher withdrawals during the years your income is lower and you're in a lower tax bracket, and do the reverse when you're in a higher tax bracket.
Managing an Inherited IRA
An inherited IRA is a potentially life-changing gift. The money in the account could help you pay off your student loan debt, pay down your mortgage, buy your first home, save for your children's college education or save for your retirement.
But the rules can be confusing. If you know you're inheriting an IRA, speak with a tax professional who can help you manage the account and your tax obligations. Taking this step could ensure that you reap the most benefit from the financial legacy your loved one has left you.