Inherited IRAs and What to Do With Them

IRA Basics

The Individual Retirement Account, or IRA, may be one of the best tools the average investor has to build wealth in a tax and cost-efficient manner. An IRA gives the investor a tax break when they contribute to it. Put one dollar in an IRA and you reduce your taxable income by one dollar, meaning your tax bill is smaller. The account then (hopefully) grows tax-deferred because it is invested in a combination of stocks and bonds. When you are retired and ready to use that money, the tax comes due when you make withdrawals from the account.

The IRA also has an opposite number. A yin to its yang. A left hand to its right hand. A… well you get the picture. This is the Roth IRA. A Roth IRA works in exactly the opposite way. When you contribute to your account you get no tax benefit. However, the funds in the account can be taken out tax-free after age 59 ½.

For more insights into the basics of an IRA, check out FINRA’s article here.

Inherited IRAs

Life happens and it’s possible that the owner of an IRA passes away before they empty the account. When this occurs, several things can happen to the account based on who inherits it.

Spouses have the most flexibility here. A spouse can inherit an IRA and treat it as their own. This gives them the ability to take over the account and have fewer strings attached to what they do with the money. When a non-spouse receives the account, it becomes an Inherited IRA (barring some exceptions). Inherited IRAs come with a time limit. The beneficiary has 10 years from the date of the original owner’s death to empty that account. This is a recent change to the rules based on the SECURE act of 2019. Remember that you get a tax benefit when you contribute to an IRA, which means you are deferring the payment of tax on those dollars. The 10-year rule was implemented as a way for the government to ensure that you pay those taxes sooner rather than later.

What to do with an Inherited IRA

If you have received or are expecting to receive an inherited IRA, there are several things that you need to do:

  1. Know your 10-year rule. There are some exceptions to this rule. These typically include children under 18, disabled individuals, or a beneficiary that is less than 10 years younger than the deceased. If you do not fall into one of those categories, then you need to empty the account by December 31st of the 10th year after the original owner passed away. Know your deadline to empty the account, mark it in your calendar, and give yourself a few week’s grace period to account for unforeseen delays in processing times.
  2. Understand the investments in the account. IRAs can be invested in a wide range of investment products such as stocks, bonds, mutual funds, and ETFs. You need to understand the key characteristics of the investments that the original owner chose and consider whether they are a good fit for you as well. A good example would be inheriting an IRA from an elderly parent or grandparent that has lots of bonds. Bonds are typically used more when you are older and seek stability and income generation. In contrast, a younger individual might be better off holding more stocks to benefit from the price appreciation that is common there. Click here to learn more about the different types of investments and what they mean.
  3. Know when to ask for help. You may be unsure whether you qualify for an exception to the 10-year rule, or how to time the distribution of the account to minimize taxes. You may not understand the investments in the account and would like some help in how to set it up properly. You may just want someone else to take care of it, so you don’t have to worry about getting it wrong. For any of these scenarios it is a good idea to seek professional financial advice. When evaluating a financial professional, it is important to consider how they get paid and whether they have your best interests at heart. To learn more about this, check out Steve Swicegood’s article on why a financial planner that uses a retainer model is a good choice.

IRAs can be a fantastic retirement planning tool and can even be passed down to the next generation. While a spousal beneficiary can treat an IRA as their own, non-spouse beneficiaries are subject to a time limit to empty the account. It will always be difficult to deal with an inherited IRA because it means that a loved one has passed away. Although people cannot be replaced, their nest egg and fruits of their labor can continue to make a positive impact on those they care about.