By mid-2022, it was estimated that 40% of American households had funds invested in an IRA. But what happens to those funds if the original owner should die while there’s still money in the account? How does a beneficiary handle the windfall? Here, we share key facts about IRAs and what you can expect if you inherit one.
It depends who you are
The rules associated with inherited IRAs differ, depending on whether you’re the spouse, a non-spouse beneficiary, or someone else. Here’s how you can tell the difference.
- Spouse: This one is easy; it means you were married to the deceased.
- Non-spouse beneficiary: You were the minor child of the original account owner, chronically ill or disabled, or a person who was not more than 10 years younger than the original account owner when they died.
- Someone else: Let’s say you’re a parent, much younger sibling, cousin, or friend. The options from which you have to choose will be slightly different.
You’ll have a decision to make
Being a beneficiary is an honor, but also a big responsibility. The first thing you’ll have to do is decide what you’re going to do with the money. Here are your primary options.
Take the cash (available to all beneficiaries)
You can always cash the IRA out in one lump sum and either spend it or tuck it away in your bank account. While this option may seem tempting, keep in mind that cashing out an IRA will result in paying income taxes on the taxable portion of the IRA distribution and missing out on potential tax-deferred growth on the balance.
Open an Inherited IRA (available to all beneficiaries)
Whether you inherit a traditional IRA, Roth IRA, rollover IRA, SEP IRA, or SIMPLE IRA, you have the option of using the money to open an Inherited IRA. Once you make the initial investment, you can’t make additional contributions, but the funds remain tax deferred and continue to grow over time. One advantage of an Inherited IRA is that it allows you to make withdrawals immediately without penalty. While Inherited IRAs make a lot of sense, when (and how) you’re expected to liquidate the account depends on whether you’re a spouse, non-spouse beneficiary, or someone else.
Roll it into an existing IRA (available to spouse only)
If an IRA is left to you by your spouse, you have the option of rolling the funds into an existing IRA. If that’s your first instinct, consider the following:
- The required minimum distribution (RMD) rules and withdrawal penalties are exactly as they would be if you’d always owned the asset.
- If your spouse failed to withdraw the RMD prior to death, any undistributed funds must be removed from the account.
Choose not to accept the inheritance (available to all beneficiaries)
You always have the option of saying, “No, thank you.” Let’s say your financial situation is solid – perhaps you have a fully stocked emergency fund, have been saving for decades in a brokerage account, and have your own retirement savings all set (or nearly set) to go — and you believe the next eligible beneficiary would benefit from the money left in the IRA more. If so, speak with an attorney about passing on the inheritance yourself. This option is actually a bit complicated, so if your desire is to ensure the next eligible beneficiary receives the inheritance, action must be taken within nine months of the original account owner’s death.
Losing someone you care about is hard, made even more difficult when you have dozens of decisions to make. Still, if someone cares enough about you to name you as beneficiary on their IRA, do yourself (and them) a favor by reviewing your options and making the most of what they leave behind.
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