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Do You Know the Rules for Inherited IRAs?

We’re in the midst of a massive generational wealth transfer, and much of that is being done in the form of inherited IRAs.

For spouses, the rules are quite simple: the inherited IRA can be drawn down over the course of the beneficiary’s life expectancy, as assessed by IRS distribution tables. Know that up to $1 million in retirement assets are shielded from creditors, and some people unwittingly exceed this threshold upon inheritance.

For widowed spouses younger than 59 1/2, elect to roll over the IRA into a new “inherited IRA” account rather than commingle it with your IRA. That way, you can avoid the 10% penalty upon early withdrawals.

If you have inherited an employer-sponsored retirement account, check with the plan sponsor, as some apply their own rules around how accounts are rolled over and when funds must be distributed.

Non-Spouse Inherited IRAs

For non-spouses that inherit an IRA, the rules get trickier. 

If the donor of the funds was under 70½ when they dies, then you must begin to take Required Minimum Distributions (RMDs) no later than December 31 of the year after death, However, you can delay distributions until December 31 of the fifth year, but must liquidate the account that that time.

Why would someone do that? Often, because they are still working now but expect to stop working within five years, at which time they will be in a lower tax bracket.

Most of the time, an account holder is older than 70 ½ at the time of death. If that’s the case, RMDs must start by December 31 of the year after death. But, if the original account holder did not take an RMD for the year in which he or she died, you must take at least that amount as a distribution by the end of the current year.

You can offset the impact of withdrawing funds from the inherited IRA too quickly by adopting a “stretch IRA.” Although you must start to take distributions right away, you can elect to receive distributions each year based on your life expectancy. For example, if a 57-year-old person inherits an IRA, the appropriate life expectancy factor is 26 year (though that figure is rising). Therefore, under the stretch IRA rules, the person will need to take out 1/26 of the beginning account balance for the year. The next year, the required minimum distribution will be 1/5 of the updated accounted balance at the beginning of that year. Subsequently, the RMDs will be 1/24, 1/23, and so on.