If you’ve inherited an IRA, you probably have a lot of questions. Before you make any decisions, you should understand the tax implications and how your choices affect your income currently as well as for the long term. The available options vary based on your relationship with the original IRA owner, your age, and whether the IRA is a traditional or Roth IRA.
Inheriting an IRA from Your Spouse
If you inherit an IRA from your spouse, there are four main options:
1. Take a Lump Sum Distribution
Taking a lump sum distribution just means that you are cashing out the entire IRA. This can be an effective option if the account is small or if you need funds right away. However, you will have to pay income tax on the distribution — your income tax rate varies based on your income and tax bracket.
2. Set Up Lifetime Distributions
If you prefer to spread out the payments, you can set up an inherited IRA and take lifetime distributions from it. You can start the distributions when you open the account. The fund manager will calculate distributions so they are likely to last through your lifetime — typically, fund managers use actuarial tables to estimate this information.
You can delay the distributions if you like, but they must start the last day of the year that the deceased would have turned 70 ½. If your spouse was already past the age of 70 ½ at the time of death, distributions start the last day of the year following death.
3. Use the Five-Year Plan
With the five-year plan, you also set up an inherited IRA, but instead of distributions lasting your lifetime, they only last for the next five years. However, you do have to pay income tax on distributions.
4. Transfer the Account to Your Name
If you want to take over ownership of the IRA, you may roll your spouse’s IRA into your existing IRA, open a new IRA to roll the account into, or put the account into your name.
With this option, all of the usual IRA rules apply to you, as if you owned the IRA from the beginning. Namely, if you take withdrawals before age 59.5, you will face a 10 percent early withdrawal penalty. After that point, disbursements are only subject to income tax. If you don’t start taking distributions at age 59 ½, they will need to start at age 70 ½.
Inheriting an IRA from a Non-Spouse
If you inherit an IRA from someone who is not your spouse, you may use the first three options explained above. To recap, that means you can take a lump sum or open an inherited IRA and spread the assets over five years, over your lifetime, or simply take required minimum distributions based on your life expectancy. The only option that you can’t take is to simply take over ownership of the IRA. That option is reserved for spouses.
Inheriting a Roth IRA
The key difference between Roth and traditional IRAs is how they are taxed. As indicated above, distributions from traditional IRAs are subject to income tax when the payments are made to an heir. In contrast, distributions from Roth IRAs are not taxed.
If you inherit a Roth IRA, you have the same options explained above. Whether you take lifetime distributions, five year distributions or a lump sum, the money is not subject to income tax as long as the account is at least five years old. If the Roth IRA is less than five years old, you should talk with an accountant about tax considerations.
Now, that you know what happens to an inherited IRA, you may be wondering about your own IRA. Have you named a beneficiary and contingent beneficiary? Do they know what to do if they inherit your account?
Don’t make unforeseen mistakes with your IRA. Contact BP Financial for more information.