As the U.S. population ages, it is common to inherit an IRA from Mom or Dad, an aunt or uncle, or even a sibling or friend. This often happens when you are in or near retirement. You have a few choices on how you treat this IRA. (If you inherited an IRA from your spouse, different options apply.)
Many people think they can roll an inherited IRA into their own IRA. Unfortunately, if you inherited an IRA from someone who is not your spouse, you cannot roll the account into your own IRA or treat it as your own. Instead. You must choose from the options outlined below.
- IRA beneficiaries are determined by the account's designation, which supersedes the terms of a will or trust.
- There’s no 10% early withdrawal tax penalty if you want to cash in an inherited IRA, but you only have five years to do so.
- On December 20, 2019, the SECURE Act passed, requiring that non-spouse beneficiaries of IRAs must cash in the asset by December 31 of the 10th year after the original owner’s death.
- Some beneficiaries may be still be exempt from the SECURE Act rule if their benefactor passed prior to January 1, 2020.
Cash in the IRA Now or Within Five Years
You always have the option of cashing in an inherited IRA. You will pay taxes on the amount of the distribution but no 10% IRA early withdrawal penalty tax. If you choose this option, you must cash in the entire inherited IRA by December 31 of the fifth year following the original IRA owner’s death. Although no penalty tax applies, this may not be your best option. Cashing in a large IRA could mean that up to 37% of it would go right to federal taxes. State income taxes will apply, too.
The beneficiary must be an individual (not a trust or a company) and must have been named by the original owner. Other rules apply if the beneficiary is a trust or company.
Stretch Out Your Withdrawals
As a beneficiary, you must take minimum distribution amounts from the inherited IRA each year, according to your life expectancy, using a specific set of rules. These distributions are called Required Minimum Distributions (RMDs).
Prior to the 2019 SECURE Act, you were able to set up an inherited IRA, with you as the beneficiary, and take withdrawals out slowly. This option of taking withdrawals over your life expectancy was frequently referred to as a “stretch IRA.” The nice thing about this option was that you could always withdraw the money sooner if needed. The RMD rules simply dictated the minimum you must withdraw. Withdrawing more than the minimum was always allowed.
If the original IRA owner died before December 31, 2019, the stretch IRA option is available. If the original IRA owner died on or after January 1, 2020, the SECURE Act, which eliminated the stretch IRA, requires non-spousal beneficiaries to withdraw all assets from an inherited IRA or 401(k) plan by December 31 of the 10th year following the IRA owner's death.
Exceptions to the 10-year rule include payments made to an eligible designated beneficiary (a surviving spouse, a minor child of the account owner, a disabled or chronically ill beneficiary, and a beneficiary who is not more than 10 years younger than the original IRA owner or 401(k) participant). These beneficiaries can "stretch" payments over their life expectancy.
If you are the recipient of a stretch IRA, your first required minimum distribution must occur by December 31 of the year following the year of the original IRA owner’s death. You will need the following information to calculate the required minimum distribution amount:
- Your age as of December 31 of the year following the original IRA owner’s death; and
- The account balance as of December 31 of the prior year
Use the information above in the steps outlined below:
- As a non-spouse beneficiary, you start by looking up your life expectancy as shown in Table I of IRS Publication 590. Use your age as of item 1 in the list above.
- Divide the previous year-end account balance (item 2 in the list above) by this life expectancy. That equals the amount of you are required to withdraw in the first year you must take a distribution.
- Each year thereafter, take your previous year’s life expectancy minus 1, and that becomes the new divisor to use.
Expert Tip: Tip
Using the stretch option used to be a way to reduce the amount of tax you have to pay on the withdrawals, because your total taxable income was lower.
A Trust or Other Entity Inherited the IRA
If you represent a trust or other entity that is not an individual person, a different set of rules will apply. You can cash in the IRA, and it is likely that you will have to do so within five years. The exception would be if all beneficiaries of the trust were individual people, in which case you may have the option of stretching distributions out over the life expectancy of the oldest trust beneficiary.
If you're not careful, you may end up paying more in taxes than you should. If the IRA is sizable, talk to a financial planner before doing anything. Remember, you will have as long as five years to take action. There is no need to rush the decision.
IRA beneficiaries supersede a will or trust. Make sure your beneficiary designations are up to date on your personal IRAs. If appropriate, ask family members whether you are identified as a beneficiary on their accounts as well. Having that information can be helpful when they pass away.