Understanding Your Options When You Inherit an IRA

Kevin K. Chung

Senior Financial Planner
First Republic Investment Management

September 7, 2016

If you inherit an Individual Retirement Account (IRA), you have several options for handling the account depending on certain factors; your relationship to the original account holder, the type of account that you have inherited, and the age of the original account holder when he or she passed away. It is important to carefully evaluate your available options before selecting one. One of the primary benefits of an IRA is the ability to grow assets within the IRA on a tax-deferred basis (or in the case of a Roth IRA, a tax-free basis). If desired, you may have the opportunity to continue growing the IRA either tax-deferred or tax-free, for many more years. On the other hand, choosing a route that is not optimal for your situation could result in unnecessary income taxes and early withdrawal penalties.

In general, there are four options available to someone who inherits an IRA: (1) you can rollover the IRA assets to your own IRA (only if you inherit the account from your spouse), (2) you can convert the account to an Inherited IRA, (3) you can take a lump sum distribution of the account balance, or (4) you can disclaim the account and allow the account to pass to alternate beneficiaries.

Transfer to Your Own IRA (Spousal Rollover)

If you inherit an IRA from your spouse and you are the sole beneficiary of the IRA, you have the option of transferring the IRA assets into an IRA in your own name.

With Spousal Rollovers of Traditional IRAs, you would be mandated to begin taking Required Minimum Distributions (RMDs) based on your own life expectancy when you reach age 70 ½ (the same rules as if the IRA was originally yours). If you are under age 70 ½, this option could provide you with the longest potential period of tax-deferral, since minimum distributions can be delayed until you reach age 70 ½. However, if you will need access to the IRA prior to age 59 ½, the Spousal Rollover option may not be suitable for you since distributions before age 59 ½ may be subject to a 10% early withdrawal penalty.

With Spousal Rollovers of Roth IRAs, you would not be subject to RMDs, and you would be able to take income tax-free and penalty-free distributions after age 59 ½ if you have satisfied a five-year holding period requirement.

Transfer to an Inherited IRA

As either a spouse or non-spouse beneficiary, you have the option to transfer the IRA to an Inherited IRA, which would allow the assets to continue growing tax-deferred. If you are the sole beneficiary, you would be mandated to take RMDs based on your own life expectancy.  If there are multiple IRA beneficiaries, then RMDs would be based on the life expectancy of the oldest beneficiary. However, if the IRA is split into separate IRAs before December 31 of the year after the account holder’s death, then the RMDs for each separate IRA can be based on the life expectancy of the respective beneficiary.

In general, for both Inherited Traditional IRAs and Inherited Roth IRAs, you would be required to begin taking RMDs by December 31 of the year following the original account holder’s death. .In addition to the RMDs, you have the ability to distribute some or all of the remaining balance in your Inherited IRA at any time without early withdrawal penalties, even if you are under age 59 ½. Distributions from traditional Inherited IRAs are taxable and can be included in your gross income. For spouse beneficiaries who can choose between an Inherited IRA and a Spousal Rollover IRA, an Inherited IRA may be more appropriate for individuals under age 59 ½ who need access to the IRA balances to support their living standards, since distributions from an Inherited IRA are not subject to early withdrawal penalties.  Spouses who elect the Inherited IRA option retain the ability to convert the Inherited IRA to a Spousal Rollover IRA at a later date.

If you elect an Inherited IRA, it is important to have funds transferred directly from the decedent’s IRA to the Inherited IRA (preferably at the same custodian first, if you intend to move the assets to a different custodian).

It is important to keep in mind that unlike Spousal Rollover IRAs and other IRAs, Inherited IRAs are not protected from creditors under federal bankruptcy laws.

Take a Lump Sum Distribution

If you need access to the IRA balance soon, you have the option to take a distribution of the entire IRA balance at once, or you can elect to distribute all of the IRA balance by December 31 of the fifth year after the original account holder’s death. You would be subject to income taxes on the taxable portion of the distribution in the year of the distribution, but you would not be subject to a 10% early withdrawal penalty. It is important to keep in mind that the lump sum distribution could cause you to pay income taxes at higher-than-normal tax rates. This may impact your eligibility for certain tax deductions and credits, so you should consult your tax advisor before doing so.

Disclaim the IRA

If you prefer not to accept the IRA, you could allow the account to pass to other beneficiaries by electing to “disclaim” the IRA within 9 months of the original account holder’s death, and before you have taken possession of the IRA assets.

If there are other primary beneficiaries named by the original account holder, then disclaiming the IRA would allow the account to pass proportionately to those other primary beneficiaries. In the absence of other primary beneficiaries, the “disclaimed” IRA would then pass to named contingent beneficiaries, if any, or to the original account holder’s heirs, as determined by state law. Before disclaiming any IRA assets, you should consult your tax advisor to make sure this option is appropriate for you and that you are taking the appropriate steps to disclaim.

Choosing Right

Keep in mind that no matter which option you choose, you can always take IRA distributions of more than the Required Minimum Distributions in a particular year, although some options may subject you to an early withdrawal penalty while others will not. Therefore, it generally makes sense to choose the option that gives you the greatest potential for tax deferral while minimizing the risk of owing early-withdrawal penalties.

It is important to understand and evaluate your options carefully after inheriting an IRA. Your choice could make a significant difference in the long-term value of your inheritance.

The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that First Republic (or FRIM) does not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document.

©First Republic Investment Management 2016