Inheriting an Individual Retirement Account (IRA) can be a financial windfall, but it also comes with decisions that may significantly impact your finances. Whether you’re a spouse, non-spouse, or a legal entity inheritor, understanding your options is key to making the most of this inheritance while adhering to tax rules. Here’s what you need to do next.
Step 1: Understand the Type of IRA You’ve Inherited
There are two main types of IRAs you may inherit:
- Traditional IRA: Contributions were made pre-tax, meaning distributions will be taxed as ordinary income.
- Roth IRA: Contributions were made post-tax, so distributions are generally tax-free, provided certain conditions are met.
Understanding the type of IRA will influence how you manage and withdraw funds.
Step 2: Identify Your Beneficiary Category
Your options depend on your relationship to the deceased. Beneficiaries fall into different categories:
- Spouse Beneficiaries
As a spouse, you have the most flexibility. You can:
- Roll the IRA into your own: This is often advantageous, as it treats the IRA as your own for tax purposes.
- Keep it as an inherited IRA: This requires you to follow specific distribution rules but can be beneficial if you are younger than 59½.
- Non-Spouse Beneficiaries
If you’re a non-spouse beneficiary, you cannot roll the IRA into your own, but you must generally withdraw the entire account within 10 years (known as the 10-year rule). There are no required minimum distributions (RMDs) during this time, but any withdrawals are taxable. - Eligible Designated Beneficiaries (EDBs)
EDBs include minor children of the deceased, disabled or chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased. They may stretch distributions over their life expectancy. - Entities as Beneficiaries
If a trust or charity is named, distribution options depend on how the IRA was structured and the terms of the trust.
Step 3: Review the Tax Implications
IRA distributions can significantly impact your taxes, especially if you’re withdrawing large sums. Here are some key considerations:
- Traditional IRA: Withdrawals are taxable as ordinary income, so spreading distributions over multiple years might reduce your tax burden.
- Roth IRA: Withdrawals are typically tax-free if the account has been open for at least five years. If it hasn’t, only earnings may be subject to taxes.
Step 4: Develop a Withdrawal Strategy
Your approach to withdrawals should align with your financial goals, age, and tax situation. Here are some tips:
- Consider your current tax bracket: If you’re already in a high tax bracket, plan withdrawals strategically to minimize the impact.
- Use funds wisely: Inherited IRA funds can be used for emergencies, debt repayment, or investments. Plan carefully to ensure the money supports your long-term financial health.
- Avoid penalties: Most inherited IRAs are exempt from the early withdrawal penalty, but confirm this with your financial advisor.
Step 5: Consult with Professionals
Inherited IRAs come with complex rules, and mistakes can be costly. Seek advice from:
- A financial advisor: To help you create a strategy for managing and investing the funds.
- A tax professional: To understand the tax implications and how to report distributions.
- An estate planning attorney: If you’re unsure about the legal aspects or if the IRA is part of a larger inheritance.
Step 6: Stay Informed About Rule Changes
Laws governing inherited IRAs can change, as seen with the SECURE Act of 2019, which eliminated the “stretch IRA” for most non-spouse beneficiaries. Stay updated on legislation to ensure compliance.
Final Thoughts
Inheriting an IRA is both a financial opportunity and a responsibility. By understanding your options, developing a sound withdrawal strategy, and consulting with professionals, you can make the most of this inheritance while minimizing tax liabilities and securing your financial future.
Take action now to ensure you honor the legacy of the person who left you this gift, while setting yourself up for financial success.