Rolling Over an Inherited IRA

What Does Inherited IRA Mean?

An inherited IRA is an IRA that you inherit from someone who has died.

Commonly, an heir to an inherited IRA will move assets from the original retirement account into their own IRA and then take distributions over their lifetime.

How Does an Inherited IRA Work?

In the event of the original owner’s death, a beneficiary can inherit all types of different IRAs, whether traditional, Roth, SIMPLE, or SEP IRAs.

Regardless of the type of IRA inherited, the income tax treatment will not change when it transfers from the original owner to the new beneficiary.

The rules for inherited IRAs are much more strict than regular tax-advantaged retirement accounts such as 401(k)s or Traditional IRAs.

Beneficiary distribution rules vary depending on whether you inherit from a spouse or non-spouse.

Inheriting an IRA From a Spouse

Inheriting an IRA as a surviving spouse has the most flexible choices available.

The spouse can either:

• Name themselves as the owner of the inherited IRA as if it has always been their account.
• Treat themselves as the beneficiary of the plan.
• Roll over the funds into another account such as another IRA or a qualified employer plan

• • • Option 1: Direct Trustee-to-Trustee Transaction. The inherited IRA is moved from the original plan and deposited directly into a new qualified employer plan, such as a 401(k), without any money ever touching the beneficiary's hands.

• • • Option 2: Distribution. Funds are taken from the account and will need to be transferred into another IRA within 60 days.
      
      

If the beneficiary does not transfer the funds within the given time frame, distribution earnings will incur tax as ordinary income. 

Likewise, it is important to note that any distributions from the account may be subject to penalties and income taxes. The beneficiary’s age has a role in determining whether or not they can take distribution penalty-free.

The beneficiary’s age determines the required minimum distributions to the inherited IRA.

Inheriting an IRA From a Non-Spouse

If you inherit from a non-spouse, the distribution rules are much stricter, and options available are narrower than those inherited from a spouse.

The beneficiary should take note of the following options and rules:

• Funds from the deceased person's IRA cannot be rolled over, unlike inherited IRAs from spouses.
• The beneficiary may open an account called an inherited IRA. In this case, the name of the IRA will remain under the deceased person’s name, and the person inheriting it is named as beneficiary.
• The beneficiary is not allowed to make any contributions to the inherited IRA.
• The non-spouse beneficiary may also take a lump-sum distribution instead of opening an inherited IRA. In this case, the distribution will not be subject to the 10% early withdrawal penalty even if the beneficiary takes the money before the age of 59.5 years. However, the funds will be subject to income taxes.
• Funds from the inherited IRA have to be distributed within ten years from the original owner’s death. Exceptions to this rule are when the beneficiary is the spouse or is a minor child, chronically ill or disabled, and when the beneficiary is not more than ten years younger than the account owner.

Tips for Beneficiaries of Inherited IRA

Below are some tips and helpful reminders for beneficiaries of inherited IRAs:

Take note of year-of-death required distributions.

It is important to note that the beneficiary must make minimum distribution amounts in the year of the original owner’s death.

The beneficiary's responsibility is to ensure that the inherited IRA meets the distribution requirements every year.

If the deceased owner was not required to have the RMDs, the beneficiary does not have to worry about year-of-death distribution.

Beware of taxes on the inherited IRA.

Inherited IRAs from spouses have more flexible rules when it comes to taxes.

However, non-spouse beneficiaries must abide by the tax rules and regulations strictly.

Usually, they will be required to distribute the funds within five years. Funds will be taxed like regular income, and there is an early withdrawal penalty.

Seek help from a finance professional.

A tax professional and an accountant may be of great help in guiding you on how to take care of your inherited IRA.

The inherited IRA will have the same restrictions, penalties, and limitations as the original owner.

Other issues may arise along with completing forms and distribution requirements. A tax expert can help this process along smoothly without incurring penalties.

Final Thoughts

Inheriting an IRA from a spouse is more straightforward than inheriting from a non-spouse.

A surviving spouse may have the option to roll over the inherited IRA and own the account.

On the other hand, non-spouse beneficiaries face more complex rules and regulations when taking distributions and filing tax forms.

A beneficiary may choose to open an inherited IRA instead of taking a lump-sum distribution to avoid complications.

It is important to know that both distributions will be subject to income taxes; however, there are no penalties for early withdrawal if you take funds from your inherited IRA under normal circumstances.

To avoid making mistakes when taking care of your retirement accounts as a beneficiary, consider seeking help from a financial advisor or accountant who can guide you through this process.

FAQs

1. What are required minimum distributions?

Required minimum distributions (RMDs) refer to the beneficiary’s withdrawals from an inherited IRA for tax purposes. RMDs are a safeguard against people who take advantage of retirement accounts to avoid paying taxes.

2. Is it always better for non-spouse beneficiaries to take lump-sum distributions rather than open an inherited IRA?

No. Some non-spouse beneficiaries benefit more from opening an inherited IRA than taking a lump-sum distribution. Either way, it is important to look into the taxes both distributions will impose.

3. What is the difference between required minimum distributions and year-of-death required distributions?

Required minimum distribution refers to the withdrawals beneficiaries of an inherited IRA must take for tax purposes. In contrast, year-of-death required distribution refers to the amount that must be distributed before December 31 of the year after death. If you choose not to take RMDs, your account may become taxable. On the other hand, if you fail to distribute year-of-death amounts during the right time frame, there may also be penalties.

4. How does a direct trustee-to-trustee transaction work?

A direct trustee-to-trustee transfer is when the account holder of an IRA transfers it directly to another financial institution. There will be no need for beneficiaries to take possession of the funds, eliminating the risks of keeping them in one place.

5. What are some common mistakes when rolling over inherited IRAs?

Some common mistakes that people make when rolling over their inherited IRA include taking out the money too early, paying taxes on nonqualified distributions, and underpaying RMDs.