If you are the spouse of an IRA owner who has named you as their beneficiary, it is critical that you—and the owner of the IRA—understand the rules that govern IRA inheritances. Not understanding the rules could result in beneficiaries paying higher taxes or penalties and forfeiting the opportunity for future tax-advantaged growth.
The IRS requires an IRA owner to take required minimum distributions (RMDs), which now generally begin at age 73. The previous age for RMDs was 72. So if you or your spouse turned age 72 in 2022 and had already begun taking RMDs, you and your spouse should continue to take your RMDs. These RMD rules also apply to an inherited IRA.
If you are the spouse of an IRA owner, you generally have 4 options with respect to the disposition of inherited IRA assets:
1. Roll over the assets into a new or existing IRA in your own name
As a surviving spouse, you have one option that nobody else has: rolling over inherited IRA assets into an IRA in your name and treating those assets as if they were your own. This may be a good choice if you don't have an immediate need to tap into your spouse's IRA assets and you are looking to keep the money in a tax-advantaged account for as long as possible. If you have not reached age 73, but your spouse had, this option enables you to delay taking distributions until you reach age 73 rather than continuing your spouse's RMDs.
Additionally, should your spouse have already begun taking RMDs but not taken the required amount before their passing, you will need to take the RMD for the current year. This RMD is calculated based on the longer of the remaining life expectancy or your spouse's single life expectancy.
However, if you are under age 59½ and you do need to access some or all of the assets you inherit from a traditional IRA, you will be subject to a 10% early withdrawal penalty1 if you roll those assets into your own IRA and then take a distribution. If you find yourself in this situation, consider option 2, explained below.
If you choose to roll over the inherited IRA assets to your own IRA, the rules for RMDs will still apply. This means you must withdraw a certain amount of money from your IRA each year starting in the year you turn 73.
Distributions from a traditional IRA will generally be taxed as ordinary income. However, if the original account was a Roth IRA and the assets were in the account for 5 years or more, distributions may be tax-free. In either case, the registration type of both IRAs must match in order to transfer the assets from one account to another (e.g., traditional IRA to traditional IRA or Roth IRA to Roth IRA). If the assets were not in your spouse's Roth IRA for more than 5 years, it would be best to consult a tax advisor regarding how withdrawals may be taxed, and whether it's best to roll them into your own Roth IRA or keep them separate in an inherited Roth IRA.
Your RMD amount would be calculated using your age to determine the life expectancy factor from the Uniform Lifetime Table (PDF).
2. Transfer the assets to an inherited IRA
Transferring assets to an inherited IRA may make the most sense if you are under age 59½ and need to access some or all of your spouse's IRA assets now, or before you attain the age of 59½. Why? Because you won't be subject to a 10% penalty when you take withdrawals from an inherited IRA prior to age 59½ as you would be if you were withdrawing assets from a non-inherited IRA you may own. Once you reach age 59½, or no longer need to use those assets, you might consider transferring the inherited assets into your own IRA.
Spouse inheritors also have additional rules regarding the timing of RMDs for inherited IRAs. You must begin taking RMDs in the year after the year of death, or you can delay beginning RMDs until your spouse would have turned age 73. This is good to know if you were older than your spouse. Once you reach the year that your spouse would have turned age 73, you may also want to consider transferring the inherited assets into your own IRA.
As long as your spouse was under age 73 when they died, you can withdraw inherited assets from an inherited IRA at any time, as long as the amount meets or exceeds the amount you are required to withdraw as a beneficiary. However, keep in mind that these larger distributions could push you into a higher tax bracket.
If you inherit a Roth IRA and transfer the assets to an inherited Roth IRA, your RMDs will always be treated as if your spouse were under age 73. Unlike Roth IRAs owned by the original owner, inherited Roth IRAs do require annual RMDs. You have the option to postpone these mandatory RMDs until the later of: the year in which the decedent would have attained age 73 or 12/31 of the year following the year of death. Withdrawals from inherited Roth IRAs are normally tax-free as long as the original Roth IRA was funded for 5 years or more and any assets withdrawn from converted balances have also been in the account for at least 5 years.
If you decide to establish an inherited IRA, be sure your IRA custodian registers the account properly. The account registration should include the name of the person you inherited from, an indication that the account is an IRA beneficiary distribution account, and your name, as the inheritor. Note that different IRA custodians may have varying interpretations of the IRS's rules regarding account registrations.
3. Roll over the IRA assets into a new or existing IRA and then convert the assets to a Roth IRA
If you don't anticipate needing to rely on RMDs from your spouse's IRA to pay your living expenses, you may want to consider rolling over the assets into an IRA in your name (option 1, above) and then converting the assets into a Roth IRA. This assumes that the IRA you inherited is a traditional IRA and not already a Roth IRA.
Unlike withdrawals, there are no penalties for conversions prior to age 59½; however, you will have to pay taxes on the amount of money you convert from your traditional IRA into a Roth IRA.
Therefore, converting to a Roth IRA may make sense for people who anticipate being in a higher tax bracket in the future and who have assets in a nonretirement account to pay the income tax associated with the amount converted to a Roth IRA. Ideally the taxes associated with the conversion should be covered with taxable assets rather than tax-deferred or exempt assets; otherwise, the amount used to cover the associated taxes will be considered a withdrawal and may be subject to penalties if below age 59½.
4. Disclaim (decline to inherit) all or part of the assets
If you choose this option, the IRA assets will pass to either the remaining primary beneficiaries (if you are not the sole primary beneficiary designated) or to the contingent beneficiaries named by your spouse. This could be your children or grandchildren, another relative, a trust, or a charity.
When assets pass directly to the IRA owner's children or grandchildren, the potential for tax-deferred (or tax-free) growth may be limited to a 10-year period (for an account owner who died after January 1, 2020) except for certain non-spouse beneficiaries. A minor child of the account holder, a chronically ill or disabled spouse, or individual that is less than 10 years younger than the account holder can still stretch out their RMDs over their life expectancy.
In some cases, disclaiming IRA assets can be a smart estate-planning move, especially if your spouse's estate was not structured properly. While assets you inherit from your spouse are generally not subject to estate taxes, they do become part of your estate when you die.
If you think that the inclusion of inherited IRA assets will cause the total amount of your estate to exceed your estate tax exemption amount, disclaiming all or a portion of your spouse's IRA could make sense. Note that a decision to disclaim assets must be made within 9 months of your spouse's death and before you take possession of the assets. This is an irrevocable decision. Therefore, as with any tax-related matter, it's critical that you consult a tax advisor or attorney before disclaiming IRA assets.
Review the 4 key strategies for inherited IRAs as outlined above with your financial advisor. If you have an IRA that you plan to leave to your beneficiaries, consider working with your tax advisor or estate planning attorney to update your retirement and estate plans as well.