Receiving a sizable inheritance can make a significant difference in a person’s financial life. If you find yourself in the position of inheriting an individual retirement account (IRA), it may have added value in the form of tax advantages. The tax rules and considerations of IRAs vary based on whether you are a spouse or non-spouse beneficiary, and if it’s a traditional or Roth IRA. While there are complexities to the rules you should explore, here are some basic guidelines to follow:
When a spouse inherits an IRA
If your husband or wife passes and leaves their traditional IRA, you have several options for how to manage the inheritance:
- Take ownership of the account. If you become the owner, you may contribute money on a tax-deferred basis to the account annually and adjust the investments to ensure the IRA aligns with your risk tolerance and financial goals. When you own the account, you are required to take a minimum distribution starting at age 70-1/2. Withdrawals prior to age 59-1/2 will incur a 10 percent tax penalty unless an exception applies.
- Roll the money into your IRA or a qualified employer plan. If you move the inherited money into another retirement account, the earnings will continue to grow on a tax-deferred basis. Once you do so, you will be able to make changes to the investment selections to align with your time horizon and goals. Additional fees may apply to roll over the money, so review the decision with a financial advisor. If you need to withdraw money and have yet to reach age 59-1/2, you will pay income taxes on withdrawals, in addition to a 10 percent tax penalty (unless an exception applies). Once you reach age 59-1/2, you will no longer incur the tax penalty.
- Remain the beneficiary. Choosing to remain the beneficiary may allow you to tap IRA assets prior to age 59-1/2 without incurring a tax penalty, but you will be subject to required minimum distributions each year. After turning 59-1/2, you will have the option to claim the account as your own or roll the money into your own IRA or another qualified plan as described in options one and two above.
If you inherit a Roth IRA, you may be able to take advantage of tax-free withdrawals. Required distribution rules at age 70-1/2 do not apply to Roth IRAs.
When a non-spouse inherits an IRA
You will have less flexibility if you inherit an IRA from somebody who is not your spouse. However, you will have the ability to stretch the IRA to generate income over several decades through how you manage distributions from the investments. The key is to ensure compliance with tax laws.
After the account owner’s death, you must rename the account, listed with the original owner’s name and date of death, followed by, “for the benefit of (name of beneficiary).” This will allow you to calculate required distributions based on your own life expectancy. No early withdrawal penalty is due, but if you inherit a traditional IRA, you must take distributions annually (calculated from a formula provided by the IRS) and pay the applicable taxes. Note that even with inherited Roth IRAs, a non-spouse beneficiary is required to take annual distributions.
Make the most of the opportunity
The primary benefit of inheriting an IRA (compared to most other types of assets) is that the money works in a tax-advantaged account. While you may choose to tap into assets today, leaving the money untouched may allow you to benefit from tax-deferred growth of your investment earnings for years to come.
Depending on the age at which you inherit the IRA, it may grow into an important source of retirement income later in life. Consult a financial advisor and tax professional to make sure you take the proper steps to avoid any mistakes and unnecessary taxes.
Andrew R. Petty, CRPC®, APMA®, is a Private Wealth Advisor with Marlowe, Petty & Associates, a private wealth advisory practice of Ameriprise Financial Services, Inc . He offers fee-based financial planning and asset management strategies and has been in practice for 15 years. To contact him, please call 407-249-4006, visit his website at www.marlowepetty.com or stopover at his office at 10917 Dylan Loren Circle, Suite A, Orlando, FL 32825.
Ameriprise Financial Services, Inc. and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.
Investment advisory products and services are made available through Ameriprise Financial Services, Inc., a registered investment adviser.
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