Inheriting an IRA? Understand Your Options
Understand how to manage inheriting an IRA, as well as the rules and options to make the most of your inheritance.
Managing your own retirement accounts can be confusing, but an inherited retirement account can be even more complex—especially with the rules introduced by the SECURE Act in 2019 (SECURE Act 1.0).1 The new rules only impact individuals who inherit a retirement account from someone who passed away in 2020 or later. Generally, individuals who inherited retirement accounts in 2019 or before will fall under the old rules—however, any successor beneficiary who inherits a retirement account in 2020 or after will be covered by the new rules.
SECURE Act 1.0 rules for an inherited account are based primarily on the type of beneficiary you are and your relationship to the original account owner. There are three main types of beneficiaries for a retirement account:
- Designated beneficiary: The individual listed on the retirement account who will receive it upon the owner's death.
- Eligible designated beneficiary: A special type of designated beneficiary who is "eligible" for special treatment under the SECURE Act 1.0 rules. Five types of individuals fall into this category:
- Spouse of the account owner
- Minor child2of the account owner
- Anyone who is less than 10 years younger than the account owner (for instance, a sibling)
- Chronically ill individual3
- Disabled individual4
- Beneficiary via a will or estate: The individual determined by the will or estate to receive the retirement account when no designated beneficiary is named.
A note about trusts as beneficiaries
If you inherited retirement account assets through a trust, the way the trust is structured will determine which tax rules apply. The rules for a trust can be very complicated, which is why we recommend meeting with an estate planning attorney if this is your situation.
Options for beneficiaries
The type of beneficiary you are and the age of the original account owner typically determine the actions you can take when you inherit a retirement account. However, if the original account owner was of required minimum distribution (RMD) age but hadn't taken all RMDs before death, you must withdraw their remaining RMD by the end of the current year—or risk paying up to a 25% penalty on the amount taken out—before you can do anything else.
That said, let's look at your options, including distribution requirements and any tax consequences.
"Disclaim" the inherited retirement account
Available to all beneficiaries
Regardless of your relationship with the account holder, you can opt to disclaim, or not accept, the inheritance and pass on the assets to an alternate beneficiary, such as another family member. This can be a smart option if you're financially secure and want to avoid potential tax consequences of the additional income. Be aware that you'll need to disclaim the account within nine months of the original owner's death and before taking possession of any assets.
Take a lump-sum distribution
Available to all beneficiaries
As the beneficiary, you may distribute the account assets in a lump sum without facing a 10% early withdrawal penalty. (If you inherit a Roth IRA, the account must have been open for at least five years to avoid paying a penalty.) There are a couple of downsides to distributing all the assets, however. First, if it's a tax deferred account (like a traditional IRA) the IRS will tax the funds as ordinary income, which could move you into a higher tax bracket. Also consider that by not keeping those assets in a tax-advantaged account, you could lose out on the potential benefit of any additional tax-deferred appreciation.
Transfer the funds into your own IRA
Available only to the surviving spouse
If your spouse lists you as beneficiary, you have the option to roll over the funds to your own IRA where the money can potentially continue to grow tax-free. That said, if your spouse was subject to RMDs and hadn't yet taken the whole amount, you must remove the undistributed amount for that year at the time of transfer.
Once the funds are in your account, subsequent withdrawals follow the rules of your IRA, not the inherited account. For example, if you want to withdraw funds but are not 59½, you may have to pay a 10% early withdrawal penalty. Assuming the money was tax-deferred, you'll also owe taxes on the distribution—the same as with any traditional IRA.
Open a stretch IRA
Available only to eligible designated beneficiaries (Note: There is a limit to this rule for a minor child.)
Assuming you don't need all the money at once, you could transfer the funds into an inherited IRA held in your name, sometimes referred to as a "stretch" IRA. This option enables you to take annual required minimum distributions (RMDs) over many years, allowing the bulk of the money more time to potentially grow tax-deferred.
Typically, you must begin taking RMDs no later than December 31 of the year following the original account holder's death. If the original account owner was under the RMD age, your life expectancy will be used to determine the distribution amount. If the original account owner had reached RMD age, then RMDs from the account can be spread out over your life expectancy or the remaining life expectancy of the original account holder, whichever is longer.
There are two exceptions to this general rule:
- A spouse will be able to wait to take RMDs until December 31 of the year in which the decedent would have had to take those RMDs.
- A minor child is only allowed to stretch out distributions until they reach 21, the age of majority. Once they turn 21, they must follow the 10-year rule (see option 5).
Distribute the assets within 10 years
Available to all designated beneficiaries and a minor child who has reached the age of majority
Under the 10-year rule, all assets in the inherited retirement account must be withdrawn before the end of the tenth year to avoid penalties on the undistributed amount. For a minor child, the 10-year rule kicks in once they reach age 21.
Based on proposed regulations from the IRS,5 some beneficiaries may also have to take annual RMDs depending on the age of the original account owner:
- If the original account owner was under the RMD age, you will not need to take annual RMDs.
- If the original account owner was of RMD age, you must start taking annual RMDs based on your life expectancy. If you're a designated beneficiary, you must start taking RMDs beginning December 31 of the year following the original account holder's death. If you inherited the account as a minor child, your first RMD must be taken by December 31 of the year of your 21st birthday.
A note about the proposed 10-year rule regulations
In a recent notice (2023-54), the IRS stated there will be no penalties for beneficiaries (covered under the proposed 10-year rule regulations) who fail to take an RMD in 2023. This extends the previous guidance issued last year that removed the RMD penalties for 2021 and 2022.
Distribute assets received through a will or estate
Generally required by those who are not designated beneficiaries
If you're not listed as a designated beneficiary on the retirement account, you likely inherited the account via a will or the estate. In this situation, the age of the original account owner will determine how you must distribute the assets:
- If the original owner was under the RMD age, the 5-year rule applies. Under this rule, you won't have an annual RMD, but you must withdraw all assets within five years of the owner's death or else pay a penalty on any remaining amount.
- If the original owner was of RMD age, you generally must take RMDs over the remaining life expectancy of the original account owner.
Given the complexity of these new rules, a tax, estate, or financial advisor can provide guidance on your options, explain requirements, and help you implement a tax-efficient withdrawal strategy if you inherit a retirement account. If you need to name a beneficiary to your own retirement accounts, it's a good idea to meet with an tax, estate or financial planning professional to make sure your accounts are set up to carry out your wishes.
1The options discussed in this article are strictly for individuals who inherited a retirement account in 2020 and onward. Inherited accounts whose owner died in 2019 or before are not affected by SECURE Act 1.0. Trust or estate beneficiaries should consult with an estate or financial planner.
2This rule applies only to the direct descendant, not a grandchild, under age 21.
3The beneficiary must be chronically ill, as defined by IRC 7702B(c)(2), at the date of the account owner's death.
4The individual must be disabled, as defined by IRC 72(m)(7), at the date of the account owner's death.