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.
"While the rationale behind the creation of IRAs was quite simple, the rules for inheriting and distributing assets upon the death of an IRA owner have become anything but," says Ken Hevert, senior vice president of retirement products at Fidelity. "If IRA owners and their beneficiaries are not careful, they could end up paying higher taxes or penalties and forfeiting the opportunity for future tax-advantaged growth."
The IRS requires IRA owners to take required minimum distributions (RMDs), generally starting the year in which they turn 70½ years old.1 RMD rules also apply to an inherited IRA, and may even apply to those inherited by you as a spouse—depending on your situation and the option you choose.
Your ultimate decision will be determined by your age, the age of your spouse, your need for income from your inherited IRA assets, the type of IRA you inherit, and, possibly, any creditor protection concerns. Be sure to consider all your available options and the applicable fees and features of each before moving any retirement assets.
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 70½ but your spouse had, this option enables you to delay taking distributions until you reach age 70½, rather than continuing your spouse's RMDs.
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 penalty 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, including inherited assets, each year once you reach age 70½. Your RMD amount would be calculated using your age to determine the life expectancy factor from the Uniform Lifetime Table (PDF).
Keep in mind that if your spouse was age 70½ or older at the time of death, you will need to determine whether they met the RMD for the year in which they passed away. If your spouse did not meet the RMD, you must take an RMD for that calendar year by December 31. However, this distribution must be reported under your Social Security number, not your spouse's. The year-of-death RMD will be calculated using your spouse’s age and life expectancy. If you fail to meet the December 31 deadline, you may be subject to an IRS penalty equal to 50% of the amount not withdrawn. For deaths that occur late in the year, consider filing IRS Form 5329 with a letter of explanation, to request a waiver of the penalty if you missed the deadline.
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.
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 can begin taking RMDs in the year after the year of death, or you can delay beginning RMDs until your spouse would have turned age 70½. This is good to know if you were older than your spouse. The RMD amounts will be based on the IRS Uniform Lifetime Table (PDF), based on your spouse's age. Once you reach the year that your spouse would have turned age 70½, you may also want to consider transferring the inherited assets into your own IRA.
Another option is to invoke the 5-year rule. As long as your spouse was under age 70½ when they died, you have 5 years during which you can withdraw inherited assets from an inherited IRA at any time, in any amount, as long as all the assets are withdrawn by December 31 of the 5th year following your spouse's death. 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 70½. Unlike Roth IRAs owned by the original owner, inherited Roth IRAs do require annual RMDs, and you must begin RMDs by December 31 of the year following your spouse's death. These RMDs will be based on the Single Life Expectancy Table. Or you may elect to take distributions under the 5-year rule. Withdrawals from inherited Roth IRAs are normally tax-free as long as the original Roth IRA was funded for 5 years or more.
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 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.
With a Roth IRA, contributions are not tax deductible, but you pay no tax when you withdraw assets, provided certain conditions are met.2 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/exempt assets.
4. Disclaim (decline to inherit) all or part of the assets
If you choose this option, the IRA assets will pass to your spouse's contingent beneficiaries. 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 will be stretched out over a much longer period. Though the children or grandchildren will need to begin taking RMDs in the year after the IRA owner's death, RMD calculations will be based on the longer life expectancies of these younger inheritors.
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. Be sure to consult a tax professional or attorney.
If you think that the inclusion of inherited IRA assets will cause the total amount of your estate to exceed the estate tax exemption limit for married couples, 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.
Other key points to remember
Pay close attention to your first withdrawal.
A separate RMD will be required if the original IRA owner was 70½ or older at the time of their death and they didn't take the first RMD before passing away. If that's the case, this money must be distributed to you after transferring the rest of the assets to an inherited IRA in your name. Also, the money must be distributed by December 31 of the year in which the IRA owner died.
The amount of that RMD will be based on the IRA owner's age, but the assets will be distributed to you under your Social Security number. You should consult a tax advisor to ensure that this "year-of-death" RMD is properly reported to the IRS.
Contact your financial provider to inquire about how it handles year-of-death distributions, as some firms may differ in the way they provide this service.
Confirm that your spouse's beneficiaries are up to date. As life events such as marriages, divorces, and deaths occur, it's in your best interest (and your spouse's) to confirm that the beneficiary designations are up to date. Remember that the IRA beneficiary designations supersede any relevant directions included in a will.
Request a trustee-to-trustee transfer. No matter which option you choose, make sure that any assets transfer directly from one account to another or from one IRA custodian to another. There is no option for a 60-day rollover when a nonspouse beneficiary is inheriting IRA assets, and a spouse beneficiary's rollover options may be limited. If you receive a check, the money will generally be taxed as ordinary income, and will be ineligible to be deposited into an inherited IRA you may own at another firm or back into the inherited IRA that it was withdrawn from to begin with.
Generally, commingling of inherited IRAs is not permitted. If you inherit IRAs from your spouse and also inherit IRAs from someone else, you cannot combine them into a single inherited IRA. As for commingling IRAs of the same account type, the answer differs when they were inherited from the same original owner, which is allowed. Consult a tax advisor regarding these situations. Distribution rules will vary for entities such as trusts, estates, or charities. 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.
Also, note that the Supreme Court ruled that an inherited IRA held by a nonspouse beneficiary is not exempt from attachment by creditors under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. While some states have laws that still may protect inherited IRAs, for a nonspouse beneficiary living in a state without such laws, the inherited IRA is effectively now treated as any other account owned by the beneficiary for bankruptcy purposes, and may not be protected under bankruptcy from claims by creditors. It is not clear whether and how this decision affects an inherited IRA held by a spousal beneficiary. You should speak with a lawyer or tax advisor before taking any distribution from a retirement account, particularly if you have specific questions regarding protection from creditors.
Next steps to consider
Take advantage of potential tax-deferred or tax-free growth.
Find out if you're contributing enough to your retirement savings.
If you own a traditional IRA, learn about withdrawals you're required to take.
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917