When you inherit an individual retirement account, your options depend primarily on your relationship to the original account holder — i.e., if you’re a spouse or not — and whether you’re the beneficiary of a traditional or Roth IRA.
Below are guidelines on the most common scenarios IRA beneficiaries face. In some situations you will need to transfer funds from the deceased’s account into an IRA in your name. (See cheatgame.info’s top picks for best IRA accounts if you need to set up an account to receive the money.)
If you’re feeling overwhelmed by the nuances of inherited IRA rules, we recommend consulting a financial advisor to avoid unnecessary taxes or penalties.
Spouses inheriting a traditional IRA
If you’re a spouse inheriting a traditional IRA you have four main options:
Option 1: You can take over the IRA (also known as a spousal transfer or “assuming” the IRA). When you assume an IRA you become the account holder, and the IRS treats it as though it had been yours all along. You can do this by designating yourself as the owner or rolling the money into an existing traditional IRA or workplace retirement account with the same tax treatment, such as a 401(k), 403(b) or 457(b).
Option 2: You can open an inherited IRA. If you’re a spouse but not the sole beneficiary, you’ll have to do this instead of assuming the IRA. The rules here are less flexible: Instead of taking over the account, you and everyone else who is named a beneficiary must establish separate inherited IRA accounts in your own names to hold your portion of the assets.
Failure to comply with the rules of RMDs could cause the IRS to charge a hefty penalty fee: 50% of the amount that wasn’t distributed. To get this part right, we encourage you to consult with the original source — the IRS FAQ on IRA RMDs — or a financial planner.
Option 3: You can renounce (or disclaim) the IRA. Just as it sounds, disclaiming an IRA means saying “no, thank you” to any claim on some or all of the assets within the IRA. People might disclaim an IRA if they want the money to pass along to a loved one or entity, such as a charity, that has been named the secondary/contingent beneficiary, or if they want to avoid having to pay federal or estate taxes on the inheritance.
Option 4: You can cash out the IRA. This is called a lump-sum distribution, and it comes with more potential consequences than the options above — more on this below.
Non-spouses inheriting a traditional IRA
Option 1: You can open an inherited IRA. This means transferring the assets into a new IRA that you set up and formally name as an inherited IRA; for example, (Name of Deceased Owner) for the benefit of (Your Name). Non-spouses are not allowed to roll the money from an inherited IRA into an existing IRA. This also means no additional contributions are allowed.
Option 2: You can renounce (or disclaim) the IRA. If you don’t want to deal with any pesky tax issues or wish the money to pass along to the next beneficiary in line, you can refuse any claim on the assets in the IRA.
Option 3: You can cash out the IRA. Called a lump-sum distribution, this comes with more potential consequences than the options above. See the next section for details.
What happens if you cash out an inherited traditional IRA?
Before you cash out an account all at once, consider the consequences of going with the “Vegas or bust” option: You will get a bill for taxes from Uncle Sam.
Withdrawals from a traditional IRA are taxable as income since the original account holder likely used pretax dollars to fund the account. If the amount you’re inheriting is big enough, it may bump you up to a higher tax bracket, which in turn may trigger a higher tax rate on the withdrawals.
On the brighter side, beneficiaries who go with the lump-sum option won’t have to pay the 10% early withdrawal penalty, even if they aren’t yet 59½ years old.
For detailed rules for beneficiaries of a traditional IRA, see the IRS’ publication 590-B. Click on “IRA Beneficiaries” in the table of contents to jump straight to the good stuff.
Spouses inheriting a Roth IRA
The IRS has different rules when it comes to inheriting Roth IRAs without triggering unnecessary taxes. Three options for spouses are:
Option 1: You can take over the IRA (known as a spousal transfer or “assume”). If you’re a spouse and the sole beneficiary of a Roth IRA, the IRS says you can treat the money as your own after you transfer the assets from the deceased’s account into your existing Roth IRA or into a new account set up for this purpose.
Beneficiaries who decide to start taking distributions benefit from the same rule that applied to the original account holder: Withdrawals of contributions are tax-free at any time. But tread lightly when it comes to earnings: Withdrawing earnings from an inherited Roth before age 59½ from an account that’s not at least 5 years old will generally trigger an IRS bill.
Option 2: You can open an inherited IRA. If you’re a spouse but not the sole beneficiary of the account, you may need to transfer the money into an inherited IRA that is held in your name. Other beneficiaries will need to do the same.
Required distributions can be paid out using either of these two options:
- The life expectancy method, spread out over your lifetime based on this IRS table. Going this route allows any assets that aren’t distributed by the end of the required period to continue to grow tax-free.
- The five-year method. You can take the money whenever you want during that five-year period, but assets must be distributed by Dec. 31 of the fifth year after the account holder died.
Option 3: You can take a lump-sum distribution. You can simply withdraw the cash from an inherited Roth IRA, but there are potential tax implications here. Skip to the cashing out section below if you’re considering this.
Non-spouses inheriting a Roth IRA
Option 1: You can open an inherited IRA. The beauty of a Roth IRA for the original account holder is that he or she was not required to start taking minimum distributions by age 70½ and could let the money continue to marinate in the account tax-free. That perk doesn’t transfer to non-spouses inheriting a Roth IRA.
If a family member or friend named you as a beneficiary on a Roth IRA, it’s generally mandatory to start taking distributions in a timely manner.
- With the life expectancy method, you must start taking distributions by Dec. 31 of the year following the death of the original account holder. You won’t incur a 10% early withdrawal penalty, but you may owe taxes on earnings you withdraw that haven’t met the Roth’s five-year holding period rule. (Our Inherited Roth IRA RMD calculator shows how much money the IRS says you need to withdraw from the account.)
- With the five-year method, the Roth must be fully paid out by Dec. 31 of the fifth calendar year after the year the owner died. You’re free to take them out at your leisure during those five years and, as with the life expectancy method, you’ll only owe taxes on distributions of earnings (not contributions) that have not yet met the five-year rule.
Option 2: You can take a lump-sum distribution. It is possible to withdraw the cash from your inherited Roth IRA, but there are a few things you should know first. See the next section for details.
What happens if you cash out an inherited Roth IRA?
Cashing out an inherited Roth IRA has fewer unsavory consequences than cashing out an inherited traditional IRA. That’s because beneficiaries can withdraw contributions from a Roth IRA tax-free at any time. And as long as the account had been open for at least five years at the time the account holder died, earnings can be withdrawn tax-free, too.
Nor are Roth IRA heirs subject to the IRS’ 10% early withdrawal penalty by cashing in before age 59½, the age at which Uncle Sam starts allowing retirement account withdrawals. But that doesn’t mean you’re completely off the hook with the IRS.
If the Roth IRA was less than 5 years old at the original owner’s death, no matter your relation to the deceased, you’ll owe taxes on the earnings when taking a lump-sum distribution. So unless you have an immediate need for the money, it generally makes sense to roll the money into an inherited Roth IRA and take advantage of many more years of tax-free investment growth.
Need to transfer money? Compare IRA providers