If you have a loved one who recently passed away and left you their retirement savings, you may be wondering what to do with an inherited IRA. Should you cash out the inherited IRA or keep growing the balance?

The answer is complicated. There are different rules guiding what you can do with an inherited IRA, based on the type of the IRA, the age of your loved one when they passed, and your relationship with them. Because an IRA is a tax-advantaged account, these rules are set by the IRS.

Below are the options available to you, as well as other issues worth considering.

What Is an Inherited IRA?

An inherited IRA is a retirement account passed to a beneficiary when someone dies. Because of this, inherited IRAs are often called beneficiary IRAs.

Any type of IRA can be inherited, including Roth IRAs, Traditional IRAs, SEP IRAs, etc. Each of these accounts can be inherited by one or more beneficiaries.

Inherited IRA

Who Can Inherit an IRA?

Anyone can inherit an IRA. The most common beneficiary is a spouse, but the person who owns the IRA can make anyone a beneficiary. This includes a child, distant relative, friend, or entity (i.e., a trust).

If the person who passed on did not set a beneficiary, then inheritance will be determined by your state’s estate laws. This can often result in multiple individuals inheriting a single account. For instance, three children could be equal beneficiaries of a deceased parent’s IRA.

📚 Learn more: Planning for the future means understanding all outcomes; delve into our guide detailing what happens to your 401(k) when you die.

What to Do With an Inherited IRA as a Spouse

As the deceased’s spouse, you have a few extra options on what you can do with an inherited IRA. Here are the 4 main ones.

1. Transfer the IRA to Your Name (or Roll Over)

When considering what to do with an inherited IRA as a spouse, you have a unique option: treating the inherited IRA account as your own. This means you can either establish a new IRA in your name using its funds or roll over the inherited IRA into an existing IRA account you already have.

IRAs have to be rolled over to an IRA of the same type, i.e., traditional IRA to a traditional IRA or Roth IRA to a Roth IRA.

This solution can help you avoid paying taxes on the inherited account until you start taking disbursements when you reach retirement age.

There are two rules regarding this option:

  1. You have to be the sole beneficiary.
  2. At the time of death, your spouse was not required to take an RMD (required minimum distribution).

⚠️ Warning: If your spouse was required to take an RMD the year they passed away, you will need to take a disbursement in that amount. If you are younger than 59 ½, this will result in a 10% early withdrawal penalty.

2. Open an Inherited IRA

Navigating through what to do with an inherited IRA can often present various paths, each offering unique financial implications. A great option is opening an inherited IRA, as it gives you more flexibility in when and how you want to take disbursements. There are 3 main options:

  1. Start taking disbursements over the course of 10 years.
  2. Take disbursements for the duration of your life expectancy.
  3. Wait until your deceased spouse would have needed to take disbursements (age 73).

There are quite a few tax and budgeting benefits with these options.

Choosing #1 allows you to start taking money now and spread the tax hit over 10 years.

In contrast, choosing #3 can help you delay paying taxes until you are required to take disbursements in the year your late spouse would have turned 73. This can be particularly useful if your spouse was younger than you.

👉 Note: If your spouse had reached RMD age when they passed, the only option available for opening an inherited IRA is #2.

3. Convert to Roth IRA

If you’re wondering what to do with an inherited IRA and anticipate being in a higher tax bracket when you retire compared to now, then converting the inherited IRA into a Roth IRA could be a good solution.

To do this, you must first put the IRA into your name (transfer IRA option). Then, you can convert the traditional IRA into a Roth IRA.

You will need to pay taxes on any amount you convert, but there is no early withdrawal penalty. The potentially hefty tax bill is why it is better to convert only if you expect to be in a higher tax bracket when you retire.

📚 Learn more: Thinking of switching to a Roth IRA? Get insight into the potential tax cost of Roth IRA conversions from our recent post.

4. Lump Sum Disbursement

If you want access to all the money now, you can take a lump sum disbursement. The money cashed out of the IRA will count as taxable income for the year you take the disbursement.

It’s also worth noting that since this is an inherited retirement account, no early withdrawal penalty is assessed.

A lump sum disbursement may be the best option when wondering what to do with an inherited IRA if the account value is small or you really need access to the cash. If you only need a little cash right now, pursuing the 10-year disbursement plan might be the better option.

What to Do With an Inherited IRA as a Non-spouse

Not sure what to do with an inherited IRA as a non-spouse beneficiary, like a child, sibling, friend, etc.? Your options for using the inherited IRA are more limited. Here are the 3 main options:

1. 10-Year Disbursement

When you inherit an IRA, the IRS offers a 10-year disbursement plan. This allows you to withdraw the funds from the IRA over 10 years. You can draw out money every year or let it grow tax-deferred and then take it all out in year 10.

To do this, you’ll need to transfer the funds from the IRA to an inherited IRA account in your name. Disbursements will come from this new account. If you are one of several beneficiaries, you’ll want to separate out your portion into your own account.

The 10-year disbursement option can be best if you want to give the money a chance to grow tax-deferred or spread the tax bill over 10 years.

2. Lump Sum Disbursement

You can always take a lump sum disbursement when you inherit an IRA. And because it is an inherited IRA, there is no early withdrawal penalty, regardless of your age.

A lump sum disbursement may be the best option when pondering what to do with an inherited IRA if there are multiple beneficiaries and/or a small IRA balance. Just be aware that the money could affect your taxes, especially if it increases your tax bracket for the year.

3. Stretch IRA

When wondering what to do with an inherited IRA, another good option is a stretch IRA. This option lets you stretch disbursement payments over the duration of your life. However, since the passing of the SECURE Act, the use of this type of IRA is very limited. The only beneficiaries allowed to use this IRA method are:

  • Minor children
  • Disabled individuals
  • Chronically ill individuals
  • Those within 10 years of age of the deceased (i.e., a sibling)

These individuals can choose to take disbursements based on their own life expectancy or the deceased’s life expectancy. If the deceased had already reached RMD age, then you have to take disbursements based on their life expectancy.

Disclaiming the Inherited IRA

Both spouse and non-spouse beneficiaries have one final option for handling inherited IRAs: to disclaim them. Disclaiming means you are refusing the inheritance. You can reject all of your IRA inheritance or just a portion of it.

If you are the sole beneficiary, the alternate beneficiary will then inherit the account. When there is no alternate, the next person in line, according to your state’s estate laws, will inherit the account.

If you were one of multiple beneficiaries, your share of the inherited IRA will be split among the remaining beneficiaries.

This strategy can be beneficial if you want to avoid the tax implications altogether or if you feel another beneficiary could benefit from the inherited IRA more.

For instance, if you are the spouse and the next beneficiary is your minor child, you could disclaim the IRA. Your child could then choose to use the stretch IRA method, providing them income for many years.

Other Inherited IRA Considerations

Here are some other points that you should look into when you inherit an IRA.

How Much Will I Be Taxed?

This depends on how and when you take disbursements.

All disbursements are taxable income (except for certain Roth IRA withdrawals). The more you withdraw in one year, the higher your tax bill will be.

👉 For Example

Imagine that you inherit a $1 million traditional IRA. If you take this as a lump sum disbursement, you’ll owe $328,163 in federal income taxes.

In contrast, if you choose the 10-year disbursement option, you’ll owe $14,768 a year. That $147,680 total, or nearly half of the lump sum tax bill.

The above scenario uses the 2022-2023 single tax rate, with no additional income and no state taxes.

The good news is there is no early withdrawal penalty. The exception would be if you are a spouse beneficiary who transfers the inherited IRA into your own name. If you then withdraw from the IRA before reaching 59 ½, you’ll face a 10% early withdrawal penalty.

📚 Learn more: Simplify your tax understanding with our post that breaks down the basics of “how do taxes work” for individuals.

Are Roth IRAs Different

If the IRA you inherited was a Roth IRA, then you may be able to avoid paying any taxes. Contributions to an IRA are made post-tax. This means they can be withdrawn tax and penalty-free because the money in them has already been taxed.

Interest earnings are handled a little differently.

If the Roth IRA was more than 5 years old when the original owner passed, you can withdraw earnings from the inherited IRA tax-free. For younger accounts less than 5 years old, withdrawing earnings will be taxed as regular income.

If you are a spouse beneficiary, you can roll over the inherited Roth IRA into your own Roth IRA.

Are Inherited IRAs Protected During Bankruptcy?

Unlike regular IRAs, inherited IRAs are not protected when you file for bankruptcy.

This means that creditors can go after money held in an inherited IRA.

If you are a spouse beneficiary, the rules are a little different. Transferring the IRA into your name means you are fully protected during bankruptcy. But if you keep the funds in an inherited IRA account, those funds may not be safe.

📚 Learn more: For clarity on bankruptcy types, our recent post breaks down the nuances between Chapter 7 vs. Chapter 13.

What Did the SECURE Act Change?

The SECURE Act made changes to how inherited IRAs can be disbursed. These changes went into effect for those who passed away starting in 2020.

If your loved one passed before 2020, then the rules for transferring and using the inherited IRA funds are slightly different. Here are the key differences.

  • There was a 5-year option, not a 10-year option
  • Non-spouse beneficiaries had the stretch IRA option
  • The use of the 5-year plan was much more limited than the new 10-year plan is
  • RMD age was previously 72

For further details on how IRA inheritance is affected by death prior to 2020, see the IRS’s Beneficiary page.

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