Setting up Your Future with an Inherited IRA

Estimated reading time: 3 minutes(Last Updated On: August 13, 2019)

Whether you have just inherited an IRA from your spouse, parent, or grandparent, an IRA beneficiary can potentially stand to earn thousands, if not millions, on these investments. Inherited IRAs have a few more rules than an IRA you set up yourself, so you can’t just accept the money and forget about it until your own retirement. Depending on the type of IRA you inherit and what you decide to do with it, you may owe taxes on the money or be required to take a yearly required minimum distribution (RMD). Find out more about Inherited IRA rules and how to use them to grow your own retirement below.

What is an Inherited IRA?

When a family member dies and leaves an IRA to a beneficiary, one option for the money is to transfer it to an Inherited IRA. Inherited IRAs have the advantage of allowing immediate penalty-free access to money. However, any distributions on a traditional IRA are subject to taxation and may bump you up to a higher tax bracket since it counts as income. Distributions from an Inherited Roth IRA are not subject to tax as long as the original account holder had the account for at least five years. Any money left in the account will grow tax deferred in a Traditional IRA and tax free in a Roth IRA.

A caveat to Inherited IRAs is that you must take an annual RMD based on your own life expectancy starting by December 31st of the year after the year of death. Spouses are allowed to wait to take their first RMD until the original account holder would have turned 70 ½ if that point comes later than the year after death rule. If the account was a traditional IRA and the original account holder was 70 ½ or older at the time of death, you must ensure they took their required RMD for the year to avoid owing a 50% penalty on that RMD. Even though annual RMDs are required for both Inherited IRAs and Inherited Roth IRAs, you can substantially grow the original amount for your own retirement.

Inherited IRA Growth

If a middle aged beneficiary inherits an account of $20,000 with a 6% return and only takes out annual RMDs, the account can grow to about $31,000 by the time that person reaches retirement. If a 20-year old inherited the same account and took only annual RMDs, the account could grow to $83,500 by the time they reach retirement. Some people name grandchildren rather than children on their accounts so the money has more time to grow. If the account holder names children and grandchildren as beneficiaries, the children can opt to defer the amount to the grandchildren if they don’t want or need the funds. Spouses and non-spouses can also name their own beneficiaries on an Inherited IRA in the event they die before all the funds are distributed. The younger the beneficiary is and the more money they inherit, the more money that person will have at retirement.

Inherited IRAs can be a significant gift to a beneficiary if used wisely. While a beneficiary could distribute all of the funds to themselves in one lump sum, most financial advisors would suggest keeping it in an Inherited IRA to make the most out of the money. Inherited IRAs truly are a gift that keeps on giving.

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