Inherited IRA Beneficiary Management Guide

By Mark Kennan

When someone dies with money still in an IRA, the money passes to the named beneficiary of the account. The Internal Revenue Service has strict rules regarding distributions to beneficiaries. Knowing your options for how to treat your inherited IRA will help with tax planning and avoiding unnecessary penalties.

Required Distributions

Generally, all money in an inherited IRA must be distributed by the end of the fifth year following the death of the original owner. However, if the IRA names a specific person as a beneficiary, that person has the option to take annual distributions over the life expectancy of the beneficiary or decedent, depending on when the decedent dies, rather than taking the entire amount within five years. This allows the beneficiary to keep the money in the account for a longer period, which is beneficial because the money grows without being taxed in an IRA and smaller distributions help with tax planning.

Surviving Spouses

A spouse beneficiary has additional options not available to other beneficiaries. A spouse beneficiary can choose to treat the inherited IRA as her own IRA by either renaming it or transferring the funds into her existing IRA. Treating the IRA as the surviving spouse's own allows the surviving spouse to delay required distributions from the account until the surviving spouse reaches age 70 1/2. A spouse beneficiary may also have the option of rolling funds into an employer plan, like a 401(k), if the plan allows it.

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Annual Required Distributions

A beneficiary who elects annual distributions must calculate them based on a formula set by the IRS. If the decedent died before starting required minimum distributions from the account, the balance in the account at the end of the prior year is divided by the beneficiary's life expectancy. If the decedent died after starting required minimum distributions, the beneficiary divides the balance by the longer of the beneficiary's life expectancy or the decedent's life expectancy as of the year of death. Life expectancy is based on the Single Life Expectancy Table in the appendix of IRS Publication 590. Distributions in subsequent years are based on the remaining life expectancy, that is, each year the life expectancy will be one year less than it was in the previous year.

Moving Funds

Extreme caution is required when moving funds from an inherited IRA. Distributions from the inherited IRA are ineligible to to be rolled over unless the beneficiary is a spouse, which means that once funds are removed from an inherited IRA, they can't be put back. Moving funds to a different financial institution must be done as a direct transfer and not a rollover. A transfer involves the money being moved straight from one account to another by the financial institution. When money is moved into a new account, the new account must be specifically titled as a beneficiary IRA.

Taxability of Distributions

Distributions from inherited IRAs are subject to the same income taxes as would distributions taken by the decedent. Distributions from an inherited traditional IRA are taxable. Distributions from an inherited Roth IRA are tax free if the account was open for at least five years. Since the distributions are made to an heir due to the death of the original owner, they are not subject to the early distribution penalties that generally apply to distributions taken before age 59 1/2. However, a beneficiary who fails to take required minimum distributions will be subject to a 50 percent penalty on the amount that should have been withdrawn. Even if the distribution is tax and penalty free, it must still be reported on the beneficiary's income tax return.

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Inheritance of a Traditional or Roth IRA


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