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What To Do With an Inherited IRA

| May 05, 2017
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What is it?

An Inherited IRA, also called a Beneficiary IRA, is simply a retirement account that has been passed along from a deceased individual to another person.

What can You do with it?

In regard to contributions, you cannot make any additional contributions to the account. In regard to withdrawals, you have several options. If you are the spouse of the decedent, you can just assume the IRA as your own, but if you are a non-spouse beneficiary, you have several options.

You Have 4 Options:

  1. Open an Inherited IRA: This is often called a Stretch IRA. With this option, you can keep it in a retirement account and continue to defer paying taxes on the account for your lifetime. You will, however, be subject to annual Required Minimum Distributions (RMDs). The required distribution amount will be a factor of your life expectancy. You can calculate this required distribution here.
  2. 5-Year Option: With this option, you can elect to receive the entirety of the account over a 5-year period. During this 5-year window, you can withdraw the funds however you like, without penalty, as long as the account is empty by the end of the period. Each distribution is considered taxable income.
  3. Lump-Sum Option: You can elect to receive the entirety of the account at once. The while distribution will be counted as taxable income in the year you receive it. With this option you may end up with a sizable tax bill, plus you will be forgoing the benefit of tax-deferred investing.
  4. Disclaim It: You actually have the right to refuse to accept an inheritance. When you do this, your portion of the inheritance will be distributed among the other primary or contingent beneficiaries. You will have zero say over what happens to the funds with this route. You generally have 9 months from the original owner's date of death to make this decision. It is important to consult with your attorney if you decide to go this route to ensure that you are meeting all legal requirements.

Which Option is Best?

There are many factors to consider when making your decision and some options may make sense in some situations, but not in others. Generally speaking, for a young individual, keeping the money in an IRA can be a powerful benefit over the long-term. Keep in mind this hypothetical example from Charles Schwab:

When six-year-old Tara inherited a $30,000 IRA from her grandfather, her parents decided to open an Inherited IRA with the money. By doing so, and by limiting Tara’s annual withdrawals (RMDs) to the minimum amount required, they ensured that the majority of her legacy had the potential to grow tax-deferred for decades. If the account earns 8% annually and Tara withdraws the required minimum amount over her 82-year life expectancy for 76 years, her grandfather’s initial $30,000 legacy could turn into a cumulative inheritance of $2.1 million.

How Should You Invest It?

When making any investment, you always have to keep in mind your time horizon and your tolerance for risk. Your time horizon lets you know how much risk you can afford to take on (your risk capacity), and your risk tolerance is completely unique to you. 

There is a caveat with inherited accounts that change things a little bit: the RMDs. Depending on your age, the annual required distributions can start getting quite large. When you're young they're relatively small in relation to the value of the account, but as you approach your own retirement, they grow. The reason this is an important factor to consider is because with other tax-deferred retirement accounts, you don't have to worry about taking money out until you retire or age 70½, but with an inherited account, you don't have a choice. 

You should structure your investments in a way that allows you to account for you annual distributions.

Conclusion

Inherited retirement accounts can be a tricky mix of tax, estate and investment planning and your decision should not be taken lightly. Before you act, you should carefully consider your options and make an informed decision.

Resources

https://www.irs.gov/publications/p590b/ch01.html

http://www.schwab.com/public/schwab/investing/retirement_and_planning/understanding_iras/inherited_ira

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