You wouldn’t think that inheriting an IRA (Individual Retirement Account) would be difficult, and it isn’t, as long as you avoid some of the common mistakes. Before getting into the specifics, it’s important to understand the distinction between an IRA inherited by a spouse versus a non-spouse, as the rules are different. Note: The information discussed below does not pertain to inherited Roth IRAs. Although inherited Roth IRAs do have distribution requirements, any qualified withdrawals are tax free.
When a spouse inherits an IRA, they have the option of rolling over the inherited IRA into their existing IRA or a new IRA in their name. This allows the inheriting spouse, who is less than 10 years younger, to take distributions based on their own age, using IRS Table III (“Uniform Life” table), and name their own beneficiaries. The rollover often allows the IRA to last longer as the distributions and taxes are spread over the surviving spouse’s lifetime and eventually the beneficiary’s lifetime once they inherit the IRA. If the spouse needs to access the IRA for financial reasons prior to age 59 ½, there’s no 10% early-distribution penalty but the taxable portion (i.e., pretax contributions and/or tax-deferred earnings) of any withdrawals will be treated as ordinary income and taxed at your highest tax rate. Note: If the spouse beneficiary is more than 10 years younger, use IRS Table II (“Joint Life Expectancy” table)
As for an inherited IRA by a non-spouse individual, the rules are a little different. Unlike a spouse who inherits an IRA, a non-spouse who transfers the IRA to their own IRA will immediately pay taxes on the taxable portion of the IRA distribution at the beneficiary’s highest tax rate. This can be avoided by properly titling an inherited IRA when the beneficiary performs a rollover to a separate IRA. The new IRA must reflect the previous owner’s name, date when the original owner deceased, along with a designation of the beneficiary. For example, “John Smith IRA (deceased February 25, 2014), FBO Lisa Jones, beneficiary.” FBO is an abbreviation that means “for benefit of.” Once the IRA is properly titled, you can name your own beneficiaries.
Unlike a spouse who inherits an IRA before 70 ½ years of age, a non-spouse individual must start taking penalty-free distributions immediately. If you forget to take a distribution, the penalty is 50% of the required annual withdrawal. In addition, the taxable portion of any mandatory distributions will be treated as ordinary income that you must report on your own tax return. The good news is that you can take these distributions over your own life expectancy, which will spread the tax impact, not to mention the benefit of tax-deferred earnings growth, over a much longer time frame. For non-spouses that inherit an IRA, the distribution table you need to use is IRS Table I (“Single Life Expectancy” table).
Whether you’re a spouse or non-spouse individual inheriting an IRA, avoid the mistake of taking the entire distribution as a lump sum. If you do, the taxable portion of the IRA will be taxed as ordinary income at your highest tax rate. And if the distribution is substantial, it could push you into a higher tax bracket and potentially impact other deductions and tax credits that have income phase-outs. Also, you lose the benefit of tax-deferred compounding over your lifetime. So follow these rules to make sure you postpone and/or minimize taxes as much as possible.