Inherited IRA Rules You Need To Know

What You Need to Know About Inheriting an IRA

Inherited IRA
When a loved one dies and leaves you with an inherited IRA, the rules can be very different from your existing IRAs. Stephanie Deissner / F1online / Getty Images

You've inherited, or expect to inherit, an IRA.  Statistically, the most common reason you've arrived in this position is because a family member or friend died and left you the stocksbondsmutual fundsETFsREITs, and other assets he or she acquired over a lifetime in the tax shelter.  What should you do?  What are the rules for inherited IRAs?  The tax traps?  The benefits?

In the next few minutes, we're going to take a look at all of those things so that by the end of this article, you feel more comfortable with the ground rules of an inherited IRA.

 It's not nearly as scary or confusing as you might think at first glance, though you should still go over your options with a qualified adviser given the consequences of getting it wrong.

How You Treat Your Inherited IRA Depends on Whether You Were Married to the Deceased

Before you can proceed, you need to answer two questions:

  1. Were you married to the person who left you the IRA as an inheritance?
  2. Had the IRA owner reached the age at which required minimum distributions had to be made?

Inherited IRA Scenario I: If you answered yes to both questions - you were married and your spouse had reached the age at which mandatory distributions were required (currently 70.5 years old), you have several options:

  1. Treat the inherited IRA as your own IRA, adding it to your existing retirement accounts and letting the money compound as if you had put it aside yourself all this time.
  2. Distribute the IRA balance using your own current age and a special IRS table
  1. Distribute the IRA balance using a special IRA table and
    1. Substituting your spouse's age as of his or her birthday in the year he or she died,
    2. Reducing beginning life expectancy by 1 for every year that passes, just as you would had they still been alive, and
    3. Taking at least the required minimum distribution for the year of death.

    Inherited IRA Scenario II: If you answered yes to one question but not the other - you were married but your spouse hadn't, yet, reached the age at which required minimum distributions had to be made,  you have three options:

    1. Treat the inherited IRA as your own personal IRA, adding it to your existing retirement accounts and letting the money compound as if you had put it aside yourself all this time.
    2. Keep the money in the tax shelter of the IRA for no more than 5 years.  By the end of the 5th year following the year of the death of your spouse, you must withdraw it all.
    3. Distribute the IRA balance using a special IRA table using your spouse's current age each year.

    Note that distributions do not have to begin until the original owner (your spouse) would have turned 70.5 years old.  If your spouse was younger than you, this allows you to enjoy the additional years of tax sheltered income and gains you would have enjoyed were they still alive.

    Inherited IRA Scenario III: If you answered no to the first question and yes to the second - you were not married to the IRA owner and they had already reached the age at which mandatory distributions were required, you need to use a special IRA table using one of the the following guidelines:

    1. Use either the younger of 1.) your age or 2.) the original owner's age at the birthday in the year of death
    2. Determine your age at the year-end following the year of the original owner's death
    3. Using the oldest age of multiple beneficiaries

    You'll need to reduce beginning life expectancy by 1 for each subsequent year.  Also note that in this scenario, you can take the required minimum distribution the owner would have taken in the year of death.

    Inherited IRA Scenario IV:If you answered no to both questions - you were not married to the IRA owner and they had not, yet, reached the age at which they were required to take minimum distributions, you can either:

    1. Take the entire IRA balance by the end of the 5th year following the year of death, potentially adding just shy of 6 years of additional tax-free compounding depending upon the exact date the original owner died.
    1. Distribute the IRA balance based on a special table while using your age at the year-end following the year of the owner's death, reducing beginning life expectancy by 1 for each subsequent year.

    Inherited IRA Scenario V: If the IRA were left to an estate, certain trust fund types, a charity, or for some reason had no designated beneficiary and the original IRA owner was already at the age of being forced to take required minimum distributions, then you need to use a special IRA table, going by the original owner's age as of the birthday in the year of death.  You need to then reduce beginning life expectancy by 1 for each subsequent year and you can take the required minimum distribution for the year of death.

    Inherited IRA Scenario VI: If the IRA were left to an estate, certain trust fund types, a charity, or for some reason had no designated beneficiary and the original IRA owner was young enough that he or she didn't have to take required minimum distributions, you can keep the inherited IRA in the tax shelter up to the end of the 5th year following the year of death, potentially allowing you to enjoy up to just shy of 6 years of additional tax-free compounding depending upon the exact date the original owner died.

    Inherited IRA Balances Are No Longer Bankruptcy Protected In the Same Way Your Own IRA Balances Are Thanks to a Recent Supreme Court Decision

    IRA balances are generally beyond the reach of creditors in most situations, often up into the low seven-figures.  The reason is that society wants to protect retirement assets as it would an old-fashion pension plan so we don't have elderly people living off the taxpayers' dime.  If anyone should take a loss, it should be the creditors who, in most cases, opted to extend credit in the first place.

    For a long time, inherited IRA balances had been treated similarly to the IRA balances investors built up themselves as a matter of course.  However, in June of 2014, the United States Supreme Court ruled in Clark v. Rameker that creditors can go after inherited IRA money and assets to satisfy their claims, profoundly altering the risk management landscape of the American retirement system.  (The case arose when Heidi Heffron-Clark filed for bankruptcy in 2010 and her creditors attempted to seize an inherited IRA she was left from her mother nine years earlier in 2001.)

    The Court relied on the fact that, as the inherited IRA rules we've gone over so far attest, Congress intended to treat money passed down through these tax shelters differently than money you put aside yourself into your own Traditional IRA or Roth IRA.

    The exception?  If you were married to the IRA owner and decide to go with any of the available options that allow you to roll the inherited IRA money over into your own IRA, making it subject to the same rules as your own retirement assets (including that nasty 10% early withdrawal penalty if you raid the cookie jar before you turn 59.5 years old, though there are ways to get around that, too, if you qualify).

    The lesson is clear: If you were married, don't let the money sit in the inherited IRA.  Seriously consider rolling it over to your own IRA as soon as it is intelligent to do so.