A significant percentage of U.S. households own IRAs, both traditional and Roth. According to data from the Investment Company Institute, as of 2018, 26% of U.S. households owned traditional IRAs while 17.6% owned Roth IRAs. And the assets held in IRAs are considerable.
If you or your spouse owns an IRA, what happens to its assets if one of you passes and leaves the IRA to the survivor? Handling an inherited IRA can be complex. That complexity can be magnified by your age, whether the IRA is a Roth or a traditional IRA, and whether the IRA owner had already started taking required minimum distributions (RMDs). An RMD is a federally required minimum amount of money that owners of traditional (tax-deferred) IRAs must begin withdrawing from their IRAs no later than April 1 of the year following the year they reach age 72.* There are also RMD rules that apply to traditional and Roth IRA beneficiaries.
How you handle an inherited IRA is important, especially from a tax perspective. Whether you inherit a traditional or a Roth IRA, you have several options.
Roll the money over to your own IRA. If you are under the RMD age and do not have a pressing need for the money, a rollover into your own traditional IRA allows you to prolong the tax-saving benefits of the inherited IRA. However, if you are under age 59½ and decide to tap into the money in your IRA, you will have to pay the IRS's 10% penalty on early withdrawals, unless an exception applies. If you need the IRA assets to pay bills and have reached the age when you must take RMDs from your IRA, a rollover allows you to access the IRA assets as needed or spread out the tax burden of IRA distributions over your lifetime.**
Transfer the assets into an inherited traditional IRA. Setting up an inherited IRA may be an appropriate move if you are under age 59½ and need access to the money in your deceased spouse's IRA. By transferring the money into a newly established inherited IRA, the inherited IRA assets stay separate from your other IRA assets and are subject to RMDs based on your own life expectancy. Withdrawals from the inherited IRA would not be subject to the 10% early withdrawal penalty.
Take a lump sum. If you have an immediate need for cash, then taking a lump-sum payout may be your option. Be aware, however, that you will have to pay ordinary income taxes on the full inherited amount at the time you take the lump sum.
Roll the money over to your own Roth IRA. If you have no immediate need for the money and want to extend the tax-saving benefits of the Roth IRA over your lifetime and even beyond, then rolling the money over into your own Roth account can make sense. A Roth IRA owner does not have to take RMDs during his or her lifetime.
Transfer the assets into an inherited Roth IRA. If you have a pressing need for the assets in your deceased spouse's Roth IRA but you have not yet reached age 59½, this option may make sense since the 10% early withdrawal penalty would not be imposed on taxable withdrawals from the inherited Roth IRA.
Opt for a lump sum. If the assets have been in the Roth IRA for more than five tax years following the initial contribution, you will not owe taxes when you take a lump-sum distribution. Of course, you will no longer benefit from tax-free compounding once you choose this option.
The tax laws are complex. You will certainly benefit from the input of a financial and tax professional before you make any moves regarding an inherited IRA.
*This age was increased from 70½, effective January 1, 2020. Account holders who turned 70½ before that date are subject to the old rules.
**Under the SECURE Act, passed in late 2019, beneficiaries of an inherited IRA account are required to take a full distribution of that account within 10 years after the year the original owner died. However, this 10-year rule does not apply to a spouse or other eligible designated beneficiary. Eligible designated beneficiaries are permitted to take distributions over their life expectancy if distributions begin within one year following the original owner's death. All other beneficiaries are required to distribute all the inherited assets within 10 years. This new rule is effective for accounts whose owner's date of death is after December 31, 2019.