Inheriting IRAs: A Legacy Full of Potential Pitfalls

If you inherit an individual retirement account, or IRA, there are a few key rules you should be aware of in order to avoid potential legal, financial, and tax issues. Failure to do so could result in a smaller legacy left behind and a headache for your beneficiaries.


Never Commingle Inherited IRAs with Non-Inherited IRAs


Inherited IRAs are separate financial accounts than IRAs or retirement accounts you may own and contribute to for yourself. You cannot commingle the funds from your IRAs and inherited IRAs. If you inherit multiple accounts from the same person such as your father, you can combine those accounts into a single IRA. Assets inherited from different individuals, such as your mother and father, you cannot combine those accounts. It is also important to note that you cannot combine inherited accounts of different types, such as your father’s traditional IRA and his Roth IRA.


Knowing Your Options


Once an IRA is inherited, the new owner has a few options. Beneficiaries who are spouses generally have the option to assume the account. This means that the account is now in their name and should be legally treated as such. Non-spousal beneficiaries have two options:


  • Five-Year Rule: A non-spousal IRA heir can choose to take all of the account balance within five years of the original owner’s death. This five-year provision is in place to help mitigate the potentially large tax bill that could be created in this situation. People who choose to do nothing with the account are often surprised at the end of the five-year window when the funds are distributed and the income taxes are due.


  • Inherit with RMDs: If you choose not to take the entirety of the account value over the course of five years, you have until December 31st of the year following the death of the original IRA owner to begin taking Required Minimum Distributions. Required Minimum Distributions (RMDs) are annual account withdrawals required for all IRA owners who reach age 70 ½. The minimum distribution is calculated based on the value of the account and the age of the account owner. For inherited IRA owners, RMDs are based on their own age. If you do not take your RMD, the IRS deems that your have elected the five-year rule.


You’re Not Protected From Bankruptcy


Money in IRAs or employer sponsored retirement plans, such as 401(k)s and 403(b)s is protected from creditors by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Unlike regular IRAs, inherited IRAs are not protected from bankruptcy. The Supreme Court ruled that once an IRA is inherited, it is no longer considered a “retirement” account and should not be protected from bankruptcy.


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