Understanding IRA Inheritance: A Guide for Beneficiaries

One way you might end up with a retirement account is by inheriting an IRA. If a loved one passes and leaves you the assets in an IRA, you can use these assets to your advantage. However, it’s important to realize that there are some interesting rules about how an IRA is passed on — and how you can withdraw money from it.

Beneficiaries

The first, and most important step is to understand the rules about beneficiaries. In this case, the beneficiary’s relationship to the deceased person has a major impact on how the IRA is treated, including whether or not you can continue making contributions to the retirement account, and how and when you can (or must) make withdrawals from it.

Spousal IRA inheritance. The easiest transition is when a spouse is the inheritor. You can choose to designate yourself as the owner, or as a beneficiary. By choosing to name yourself as the owner, you can roll the IRA over into your own IRA – at which point it becomes yours and all the normal traditional or Roth rules will apply to it (contributions, withdrawals, and other rules).

You may also choose to own the account as a beneficiary. This allows you, as a spouse, to withdraw from the IRA with no 10% penalty. For some of those who are not 59 1/2, it can be a good idea to continue to own the IRA as beneficiary so that there is access to the money. Realize, though, that if it is a Roth IRA account, the five-year rule applies to when the original owner opened the account. Withdraw before the five-year rule is met, and you could pay income tax (but not a 10% penalty) on the withdrawal.

Non-spousal IRA inheritance. Non-spouse beneficiaries also receive the ability to withdraw without a 10% penalty, no matter their age. However, they have to start taking distributions by December 31 of the year after inheriting. Withdrawals and required minimum distributions can become complicated when you inherit an IRA from someone who wasn’t your spouse. Here is a good explanation from SmartMoney.com. You may also find it helpful to seek professional assistance from a financial advisor or tax pro.

Rules are also different if an estate is involved. An IRA that benefits the estate has to be entirely withdrawn within five years. The exception is if the deceased was already taking required minimum distributions; distributions are then figured based on what the deceased would have been taking.

Realize that the beneficiaries named on the IRA forms trump whatever is in the will. If no beneficiaries are named, the IRA is transferred using whatever rules the custodian has for the occasion.

Transferring Inherited IRAs

When an inherited IRA is transferred from one custodian to another, you need to do what is called a “trustee-to-trustee” transfer. If you don’t do this step right, it can look like you withdrew all of the money — and it can cost you. If you aren’t the spouse, the IRA has to be retitled. This process, for inherited IRAs, requires that you include the name of the original owner and your own name. So it would be worded as: “Name of Original Owner, deceased, inherited IRA for the benefit of Name of Heir, beneficiary.”

It’s a big name, but important. You can also split an IRA, and you should do so if there are multiple beneficiaries. Each beneficiary should receive his or her own inherited IRA for the proper amount. That way, you avoid problems down the road, and each beneficiary is responsible for his or her own inherited IRA.

There are a number of rules associated with inherited IRAs (See IRS Pub 590 for full details), and it’s a good idea to have a knowledgeable attorney or advisor help you with the transfer, and help explain your options. Spouses have more options, and it’s a good idea to get advice before you do anything with an inherited IRA.