Inheriting an IRA


Inheritance is a complicated thing.

There are often emotions that surround your recent loss and you might feel unsure about what you’re supposed to do with your newfound wealth. Inheritance can become even more complicated when you inherit an IRA instead of cash. Whether your loved one has left you a Roth or Traditional IRA you have several options for incorporating it into your own financial plan.

Options if You’re a Spouse

If you’ve recently inherited an IRA from your spouse, you can do a few different things with the funds:

●      You can undergo a spousal transfer and treat the funds as your own.

●      You can open an inherited IRA.

●      You can take a lump-sum distribution.

Let’s take a look at the pros and cons of each.

Spousal Transfer

If you’re the only beneficiary on your spouse’s IRA, it may make sense to open an IRA of your own using a spousal transfer. This helps to ensure that your IRA continues to grow tax-deferred and you can name your own beneficiary and treat the account as yours.

Inherited IRA

You also have the option to open an inherited IRA. If your spouse was under 70 ½ you have the option to either open the account using either the 5-year or the life expectancy method. Using an Inherited IRA (Life Expectancy) method, you can take distributions over the course of your life. Using the Inherited IRA (5 Year) method, you’ll be able to distribute the funds up until the fifth year after your spouse has passed away. You won’t incur the 10% early withdrawal penalty if you choose the 5-year method.

Lump-Sum Distribution

In a lump-sum distribution, you’ll take all of the funds at once and cash them out to use as you please. You will be taxed fully at your income tax rate, but you won’t incur any penalties from early withdrawal of the funds from your spouse’s account.  

Keep in mind that these methods remain the same whether you’ve inherited a Traditional IRA or a Roth IRA. However, if your spouse was over 70 ½ when they passed away, the 5-year method is no longer an available option.

Options if You’re a Non-Spouse

Options for a non-spouse who has inherited a Roth or Traditional IRA are similar to those of a spouse. However, a non-spouse can’t open a Spousal Transfer IRA. If you’re in this situation, your options are limited to opening an Inherited IRA, either using the 5-Year or the Life Expectancy method, or taking a lump sum payment from the IRA that you’ve inherited.

Roth v. Traditional IRA Inheritance

Although it appears that there aren’t very many differences between inheriting a Roth IRA and a Traditional IRA, there’s something you must keep in mind: Roth IRAs have tax-efficient distribution rules, even for those who have inherited them. Although Roth IRAs are funded with after-tax dollars, as long as the account has been established for a full five years before the IRA account owner passes away, the beneficiary won’t owe any taxes on the funds they withdraw from the account. They’ll also be able to avoid the 10% early withdrawal penalty. Ultimately, inheriting a Roth IRA has more benefits than inheriting a Traditional IRA. With a Traditional IRA you may owe taxes on distributions later on in life.

What Shouldn’t You Do?

You have several different options whether you’ve recently inherited a Traditional IRA or a Roth IRA. However, there’s one thing you absolutely shouldn’t do:

You should not, under any circumstances, cash out your recently inherited IRA then go see a financial planner after the fact wondering what next steps are.

A financial planner will be able to help you navigate the tricky combination of estate, tax, and retirement planning that you’re currently in the middle of. However, if you cash it all out at once with the lump sum option, you significantly limit your choices and your ability to mitigate the impact that taxes have on your newfound wealth. After discussing your unique financial situation and long-term goals with a financial planner, you may find that the lump sum option works in your best interest. But it’s key that you allow a professional financial planner to evaluate all of your options with you to make sure you’re making the most out of your inheritance.

Inheriting a retirement account can be overwhelming, and the different options available to you as the beneficiary are far from user friendly, especially if you haven’t put much thought into a retirement plan for yourself yet! Speaking with a financial planner can help you to move past that barrier and start creating a plan that puts your inheritance to work.