What Is an Inherited IRA? 5 Rules You Should Know
Laura answers a listener question and explains what happens when a friend, family member, or spouse leaves you an IRA. There are five important rules you should know to avoid costly mistakes that could trigger huge tax penalties with an inherited IRA.
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Kathleen D. says, “My daughter is an American working and going to school in Norway. Her father died in January and left her a traditional IRA. Can she roll it over to an account in her name in the U.S.?”
Thanks for your question, Kathleen, and my condolences for the loss in your family.
As if retirement accounts weren’t confusing enough, there are special rules that apply when you inherit one.
In this post, I’ll answer Kathleen’s question and explain what happens when a friend, family member, or spouse leaves you an IRA. We’ll cover 5 important rules you should know to avoid costly mistakes that could trigger huge tax penalties.
Free Resource: Retirement Account Comparison Chart (PDF download)—handy one-page resource showing the rules for the most popular retirement accounts
What Is an IRA?
An IRA or Individual Retirement Arrangement is a special type of account that shelters contributions and investment growth from some amount of tax. These tax-advantaged accounts make it a whole lot easier to save a bigger nest egg for retirement.
The two main types are traditional and Roth IRAs. Here’s a brief summary of the major differences between them:
- Traditional IRAs defer taxes on contributions and earnings, but you have to settle up when taking withdrawals—even from an inherited account. If you take money out before reaching age 59½, you must pay income tax plus a 10% early withdrawal penalty. And you must begin taking withdrawals once you reach age 70½.
- Roth IRAs require tax on contributions before they go in the account, but allow you to withdraw contributions and earnings tax free. However, if you make Roth withdrawals before age 59½, amounts that were not previously taxed, such as investment growth, would be subject to income tax plus a 10% early withdrawal penalty. With a Roth, there is no deadline to take withdrawals.
What Is an Inherited IRA?
An inherited IRA, also known as a beneficiary IRA, is a type of IRA that was designed just for retirement plan beneficiaries. You can create either a traditional inherited IRA or a Roth inherited IRA. The custodian of the deceased person’s IRA transfers funds directly into an inherited IRA in your name.
Assuming you want to inherit the IRA you were given (you can disclaim it if not), here are the options when the deceased person was not your spouse:
- Cash it out in a lump sum distribution without creating an inherited IRA.
- Open an inherited IRA and take minimum distributions over a 5-year period
- Open an inherited IRA and take minimum distributions over your remaining life expectancy.
If you were married to the decedent, you have the above three options, plus a fourth: assume ownership by rolling over the funds into your own IRA.
See also: 10 IRA Facts Everyone Should Know