The Smart Way to Inherit an IRA

by Emily Guy Birken · 7 comments

IRA inheritance rules

Even though the majority of Americans are worried about the possibility of outliving their retirement money, passing away with a still-loaded IRA could cause its own set of headaches for your heirs.

Whether you’ve recently become the beneficiary of a loved one’s IRA, or are planning ahead in case your retirement account outlives you, here’s what you need to know about inheriting an IRA.

The Benefits of Marriage

IRA inheritance is one of many instances when the benefits for spouses are much better than they are for any other beneficiary. The surviving spouse is entitled to something known as a spousal rollover. That means that the money can be rolled over into an IRA in the surviving spouse’s own name.

From that point onward, those assets will be treated exactly the same as any other retirement assets in the surviving spouse’s name. Because of this, it is the surviving spouse’s age that’ll determine things like early-withdrawal penalties and required minimum distributions.

However, for beneficiaries who are not married to the deceased, things get a little more complicated.

Rules for Non-Spousal Beneficiaries

There are two main options for all other beneficiaries. The first rule (and default) is that beneficiaries must withdraw the whole balance of the account by the end of the fifth year after the original IRA account holder’s death. It’s important to remember, however, that the IRS will still want to take their cut of the assets, since the money went into the account pre-tax. This can cause a potentially enormous tax burden for heirs, as they’ll have to declare the IRA balance as income in the year that they withdraw it.

The second — and financially savvier — option available to non-spousal heirs is to stretch out distributions from the inherited IRA over a lifetime. This option, commonly referred to as a Stretch IRA, allows a beneficiary to withdraw a minimum amount each year, potentially for the rest of their life. Much like the required minimum distribution that an original IRA account holder could take upon reaching retirement, these minimum distributions for Stretch IRAs are calculated based on the age and life expectancy of the beneficiary.

The real benefit of stretching out an IRA’s distributions is that it allows the balance of the account to remain in place and continue to grow, making the original inheritance much larger through time and compound interest.

It’s important to note that heirs who opt for the Stretch IRA may take more than the required minimum each year — they’ll just have to pay the additional taxes.

In order to take advantage of this option, heirs must begin taking the required minimum distribution as of December 31st of the year after the original account holder’s death. Miss that deadline, and you’ll be stuck taking the five-year liquidation option.

The Bottom Line

Both heirs and account holders would do well to set up a meeting with a certified financial planner to make sure that they’re taking advantage of their assets. A professional can help an account holder double-check that all paperwork is in order and that their money will be disbursed as intended. And heirs can get great advice on what to do and when — which is doubly important in a time of grief.

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{ 7 comments… read them below or add one }

@pfinMario March 22, 2013 at 5:31 am

I will have to look into this someday when married. Until then I’ll sit sadly about how the tax code is skewed against us single folk

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SteveMcQueen March 23, 2013 at 11:43 am

Ditto! :)

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Damian March 22, 2013 at 5:59 am

If there’s anything I’ve learned in life it’s that you really need to seek professional help when dealing with anything related to money or the law!

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Gwen March 22, 2013 at 8:00 am

Great article. I’m printing it out and putting in my estate notebook in the IRA section. In the event it’s needed, whoever is administering my estate will have a gentle reminder to consider tax implications.

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Cherleen @ My Personal Finance Journey March 22, 2013 at 4:47 pm

Great article. This is very informative, especially for me and my husband who are both depending on IRA as part of our retirement money. Thank you for the information.

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Frankie's Girl April 24, 2013 at 10:17 am

My father passed away the end of 2012, and I inherited two IRAs. Something to consider, and should be check into on these that was left out of the article:

NAME your beneficiaries on your accounts! Do not put “estate” or leave out your wife, kids or friends… whomever you want the money to go to in the event you die.

My father did name my sister and myself as equal beneficiaries on one of his IRAs. No muss, no fuss transfer to an inherited IRA in my name (and my sister to hers) with a bit of paperwork and the submission of the death certificate.

The other one… well, dad never got around to naming the beneficiaries. That means that account becomes part of the estate, and is currently working through probate…AND will be subject to estate and inheritance taxes! And no matter what, it still was going to end up coming to my sister and myself just like the first IRA since we are named the only and equal heirs in his will.

If you’ve got an uncomplicated idea of who you want to inherit, then there is no sense in not putting beneficiaries on your accounts. You will avoid large taxes that way for your spouse or kids, and it makes it possible to get the funds that much sooner as well. My sister and I are lucky that the state he lived in does not do estate/inheritance taxes, but from what I’ve read, that is rare…

We let the fund manager set up all of the transfer to make sure nothing stupid happened (accidentally left off the inherited part – forcing us to take full distribution within the 5 year period).

We also tied our accounts together to get a deeper discount off of the financial management fee. We don’t have access to each other’s accounts, but the fund advisors recognize the two accounts as being a “family” unit, and saved us a few tenths of percentage points on the fees themselves (higher total of the cash in the account = less charged to pay them to keep an eye on it and move it around). Neither one of us is really into stocks and bonds, so this made the most sense for both of us.

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Frankie's Girl April 24, 2013 at 10:40 am

I meant to say that we let the fund manager set up the transfer to AVOID accidentally leaving off the inherited part that would force us to take the 5-year liquidation… that wasn’t clear. We’re good on having the minimum required distributions for our lifetimes.

Another thing – I am paying out of pocket for the quarterly fees, rather than having them taken out of the account itself. The account is doing VERY well, and I’d rather pay a couple hundred from my checking than drop the IRA’s earning potential… at least that’s what made sense to me. Hope that’s right.

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