Understand the tax and other implications when leaving IRA assets to spouse and nonspouse beneficiaries, charities, trusts, or your estate.
By Christine Benz | 09-14-17 | 05:00 AM | Email Article

Owing to longer life expectancies and related long-term care costs, inheritances have flatlined in the U.S. over the past decade: Wealth transfers as a proportion of net worth dropped to 19% in 2007 from 29% in 1989. Just a tiny share of the population receives an inheritance of more than $100,000, according to a study from the Federal Reserve Bank of Cleveland.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Data is scant on the type of inheritances people receive: Many people receive their inheritances through the sale of real estate--often a parent's home--while others receive financial assets. As of mid-2015, 26% of U.S. households owned traditional IRA assets, while another 17% of U.S. households owned Roth IRA assets, according to data from the Investment Company Institute. It stands to reason that people who inherit financial assets--rather than property--are often inheriting IRAs.

Inheriting an IRA is more complicated than inheriting a chunk of cash from a home sale, however. (Of course, many heirs get involved in prepping the family home for sale--that's another story.) Last week I outlined some factors to consider when deciding who should inherit your IRA. This week, let's take a look at the mirror image of that issue: what to do if you inherit an IRA from someone else.

The "right" answer will depend on several different factors: your relationship to the deceased, your age, whether the account is Roth or traditional, and whether the IRA owner had begun taking RMDs. There's also the most important factor of all to reckon with: Do you need the money soon, or will you be able to continue to invest it, thereby stretching out the tax benefits of the IRA wrapper? 

I've outlined the key options available in four major inheritance situations. (Note that this article only tackles IRAs that are inherited directly by individuals--that is, not through a trust or by a charity. Nor does it tackle inherited assets from a qualified retirement plan, where the rules, especially for nonspouse beneficiaries, are different.) It's also worth noting that disclaiming the IRA assets is also an option; in that instance, the assets would pass to the other beneficiaries or contingent beneficiaries.

If You're the Spouse of the Deceased and You Inherit a Traditional IRA

Option 1: Roll the money into your own IRA
This is a sensible default strategy for surviving spouses who need the IRA assets to fund their living expenses and are of RMD age themselves; rolling over the IRA assets to their own accounts enables them to continue to tap the assets as they need them and also spread out the tax burden associated with those distributions over the surviving spouse's lifetime. This strategy also wins points for simplicity, as it gives the surviving spouse the opportunity to consolidate all IRA assets into a single account.

From a tax standpoint, however, a rollover will be the most beneficial in the (fairly rare) instance that the surviving spouse is well under pre-RMD age and doesn't have an imminent need for the money from the IRA. (If the surviving spouse is younger than 59 1/2 years and cracks into the account before that age, he or she would be subject to the 10% penalty on early distributions.) Rolling over the money enables a surviving spouse to stretch out the tax-saving benefits of the IRA; he or she wouldn't have to take RMDs until age 70 1/2.

Note that the surviving spouse must take out any required minimum distributions, based on the deceased spouse's age and life expectancy, for the year in which the owner died.

Option 2: Transfer the money into an inherited IRA
Transferring the assets to an inherited IRA is different from rolling the assets into the surviving spouse's own account; the inherited IRA assets remain separate from the surviving spouse's other IRA assets and are subject to RMDs based on the surviving spouse's own life expectancy. Setting up an inherited IRA will make the most sense for younger (pre-age 59 1/2) surviving spouses who would like to tap the inherited IRA, at least in part, soon. In contrast with the rollover, discussed above, which allows penalty-free withdrawals only after the surviving spouse has turned age 59 1/2, the inherited IRA allows for penalty-free withdrawals prior to that point.

If the deceased spouse died before he or she was of RMD age, the surviving spouse can use one of a few different methods for calculating RMDs, as outlined here

Option 3: Take the money out of the IRA in a lump sum.
This strategy will only make sense if a surviving spouse has an imminent need for all of the IRA assets. It's the most punitive from a tax standpoint, in that the inheritor will pay ordinary income taxes on the whole amount at that time.

If You're the Spouse of the Deceased and You Inherit a Roth IRA

Option 1: Roll the money into your own IRA.
This is the most beneficial move, tax-wise, for inherited IRA assets; it's appropriate for spouses who don't need the assets in the IRA and would instead like to stretch out the tax-saving benefits of the Roth over their own lifetimes or even beyond, if the inheritor earmarks the assets for his or her heirs. Not only would the assets not be taxed upon withdrawal, assuming the five-year requirement was met and the surviving spouse is older than age 59 1/2, but mandatory distributions wouldn't apply. (Roth IRA assets, in contrast with traditional IRA assets, don't entail RMDs.) This isn't a good option for surviving spouses who are under age 59 1/2, in that a 10% penalty would apply. 

Option 2: Transfer the money to an inherited IRA.
Setting up an inherited IRA for a Roth IRA spousal beneficiary will generally make less sense than rolling it over to the surviving spouse's own Roth IRA, because RMDs will apply to the inherited IRA. The inherited IRA assets won't be taxed upon withdrawal, either. But rolling over the inherited Roth IRA assets to the spouse's own Roth IRA provides more of an opportunity for the tax savings to be stretched over the inheritor's lifetime and possibly passed on to heirs. On the other hand, an inherited IRA can make sense if a spouse has an imminent need for the assets in the IRA but hasn't yet attained age 59 1/2; withdrawals from the inherited IRA wouldn't be subject to the 10% penalty on early withdrawals. As with an inherited IRA composed of traditional IRA assets, a surviving spouse can use a few different methods for calculating RMDs on a Roth account, discussed here.  

Option 3: Take the money out of the IRA in a lump sum.
Anyone who takes a lump-sum distribution from a Roth IRA won't owe taxes, assuming the assets have been in the account for five years following the contribution. However, this strategy is only advisable when there's an imminent financial need, because taking the money out of the Roth means that the assets will no longer benefit from tax-free compounding.

If You're Someone Other Than the Spouse of the Deceased and You Inherit a Traditional IRA

Option 1: Roll the money into an inherited IRA.
The options are fewer--and the tax-saving opportunities fewer--for nonspouse beneficiaries. Specifically, nonspouse beneficiaries can't roll inherited IRA assets into their own accounts. Instead, if they want to maintain the assets inside of an IRA they must transfer the money to an inherited IRA.

In the case of an inherited IRA where the deceased was under age 70 1/2 and hadn't begun taking RMDs, the beneficiary must start taking RMDs based on his/her own life expectancy by Dec. 31 in the year following the year in which the deceased passed away. Alternatively, the beneficiary could delay distributions, as long as he withdraws all of the assets in the IRA within five years of the deceased person's death.

If the deceased had begun taking RMDs, beneficiaries must take distributions from an inherited IRA account during the beneficiary's own lifetime. RMDs must begin by Dec. 31 following the year of the deceased person's death. If the deceased did not take his or her RMD for the year in which he died, distributions must be made by year-end.

Option 2: Take the money out in a lump sum.
This strategy will only make sense if the beneficiary has an imminent need for the IRA assets. It's the most punitive from a tax standpoint, however, in that the inheritor will pay ordinary income taxes on the whole amount at that time.

If You're Someone Other Than the Spouse of the Deceased and You Inherit a Roth IRA

Option 1: Roll the money into an inherited Roth IRA.
Roth IRA assets inherited by a nonspouse can be transferred into an inherited IRA. RMDs apply to all other Roth IRA assets inherited by nonspouse beneficiaries: The beneficiary must receive the entire distribution by Dec. 31 of the fifth year following the year of the owner's death or elect to receive distributions during the beneficiary's own life expectancy.

Option 2: Take the money out in a lump sum.
Anyone who takes a lump-sum distribution from a Roth IRA won't owe taxes, assuming the assets have been in the account for five years following the contribution. However, this strategy is only advisable when there's an imminent financial need, because taking the money out of the Roth means that the assets will no longer benefit from tax-free compounding.

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