Inheritance rules for traditional and Roth IRAs

BY NINA SEMCZUK, CEPF SMART ASSET

Inheriting an IRA, whether a traditional or Roth account, comes with certain responsibilities. The rules for an inherited IRA depend on the specifics of your situation, as well as the deceased’s age and other circumstances. Unfortunately, you might have to make financial decisions about the account while dealing with your grief. Financial advisors work with beneficiaries to develop the best strategies. Let us look at the government’s rules and the number of potential tax penalties or benefits that can apply to you and the IRA.

What is an inherited IRA?

An inherited IRA is an individual retirement account that gets opened for a beneficiary (this could be a spouse, family member, unrelated person, trust, estate or nonprofit organization) after the original owner dies. Tax rules for beneficiaries are different, depending on whether you are a spouse or non-spouse.

IRAs are tax-advantaged accounts designed for retirement savings. They can hold stocks, mutual funds, bonds and a variety of other financial products. Your money earns interest and grows — tax-free. Until you reach retirement age, you do not pay income tax or capital gains tax on the money in the account.

There are two major types of IRAs: traditional and Roth. With traditional IRAs, you contribute pre-tax earnings which are considered tax deductible. When you retire and start taking distributions from your IRA, those distributions will be taxed as income. For Roth IRAs, you contribute taxed income (and your contributions are not tax deductible) and when you retire, your withdrawals are tax-free.

As a beneficiary, you can transfer the money from any type of IRA to a new inherited IRA in your name. Note that the SECURE Act changed IRA rules in 2019, and now non-spouse beneficiaries must take money out of the account within 10 years of the owner’s death.

Rules for inheriting a traditional IRA: Spouses

The IRS lists three options for spouses who inherit a traditional IRA. If that is you, the first option is to designate yourself as the account owner. You will put the account under your name (also known as “retitling”). This way, the account is yours to contribute to or withdraw from. Keep in mind, in most circumstances you must be 59 1/2 or older to withdraw from an IRA without penalty.

Your second option is to roll the inherited account — tax-free — into an IRA you already possess. If you have an employer retirement plan, you can roll the inherited IRA into that account, as well. In both situations, you become the owner of the IRA.

The third option is to treat the account as a beneficiary, not as the owner. This could mean withdrawing the money in a lump sum, but that is not your only choice. Treating the account as a beneficiary also means you have the option to transfer the assets to an “inherited IRA” held in your name. This will come with required minimum distributions.

For the first two options, since you are treating the assets as your own, you will have to pay a 10% penalty if you make an early withdrawal before you are 59 1/2 years old. For the third option, you must start withdrawing funds from the account once you reach 72 years of age.

Note that the SECURE Act raised the RMD age from 70 1/2 to 72. However, if you were 70 1/2 by 2019, you still had to take your first RMD by April 1, 2020. The SECURE 2.0 Act, passed at the end of 2022, raised the RMD age to 73.

Rules for inheriting a Roth IRA: Spouses

If you inherit a Roth IRA as a spouse, you can withdraw any or all the account, tax-free, provided the account has existed for at least five years. In this case, you will not be charged the 10% early withdrawal penalty.

If you would rather not take the Roth IRA as a lump sum, you have options. The better option for long-term savings is to transfer the assets to an existing Roth or to open a new Roth

IRA. The account can grow without penalty, due to the lack of required minimum distributions. You can also leave the money in the account to grow indefinitely for the next generation. This is one of the biggest differences between Roth and traditional IRAs.

Rules for inheriting an IRA: Children and other non-spouse beneficiaries

If a parent leaves you an IRA, you are the beneficiary. The IRS calls this situation a non-spouse inheritance. Parent to child is the most common nonspouse situation, but it is not exclusive. As a non-spouse beneficiary, you cannot retitle the IRA in your own name. That benefit is only available for spouses. You can, however, transfer the account into a new account. This is known as an “inherited IRA.”

You could immediately cash out traditional or Roth IRAs through a lump sum distribution. With traditional IRAs, withdrawals are taxable income. However, withdrawals from Roth IRAs (if the account was open for at least five years) are tax-free. The downside of taking all the money out immediately is that you lose the long-term benefits that occur when the money grows within the IRA. However, it is an option if you need funds right away.

If you only want to withdraw some money, but not all, you can do so. You must transfer the account to an

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