Inherited IRA from a Non-Spouse
Inherited IRA Rules for Non-Spouse Beneficiaries
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. See the article Inherited an IRA from my Spouse.)
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 the IRA as your own. Instead, you must choose from the options outlined below.
Cash in the IRA Now - Or Within 5 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 31st of the 5th 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 anywhere from 25% – 39.6% of it goes right to federal taxes. State income taxes will apply too.
For this reason, you may want to consider option 2 below.
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 these conditions don't apply.
Stretch Out Your Withdrawals
To take withdrawals out slowly, you can set up what is called an “Inherited IRA” account with you as the beneficiary. 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 and are frequently referred to as RMDs. This option of taking withdrawals over your life expectancy is frequently referred to as a “Stretch IRA”. The nice thing about this option is that you can always withdraw the money faster if needed.
The rules simply dictate the minimum you must withdraw. Withdrawing more than the minimum is always ok.
With a Stretch IRA, your first 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.
- 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. (When accessing this link scroll down to Appendix C to find the appropriate life expectancy table.)
- 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.
You can also use the third calculator listed in the 3 Good RMD Calculators list to do this math for you.
The nice thing about this stretch option is it allows you to pay taxes only on the amount withdrawn as you take it out while the remainder of the money in the account continues to grow tax-deferred.
Using the stretch option may also reduce the amount of tax you have to pay on the withdrawals because your total taxable income is lower.
For additional details see 4 Options for Non-Spouse Beneficiaries of Inherited IRAs.
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 you will have to do so within five years. The exception to this would be if all beneficiaries of the trust are individual people, then you may have the option of stretching distributions out over the life expectancy of the oldest trust beneficiary. See the Beneficiary Not an Individual section of IRS Publication 590 for details.
If you're not careful you may end up paying more in taxes than you should have. If the IRA is sizable, talk to a financial planner before doing anything. Remember, you will have as many as 5 years to take action. 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 if you are down as a beneficiary on their accounts as well. Having this information can be helpful when they pass away.