An inherited IRA is a tax-advantaged retirement plan passed from a benefactor to a beneficiary upon the benefactor's death. How an inherited IRA is handled depends on the type of retirement account and the benefactor's relationship to the beneficiary.

Taxes

An inherited IRA may come with some strings attached. If you inherit a pre-tax account such as a 401(k) or traditional IRA, all distributions will be taxed as ordinary income. The benefactor paid no taxes on the funds when they were placed into the account, so when they come out, taxes are due.

It's not as onerous as it sounds. You can pay the taxes out of the proceeds from the inherited IRA. Think of the inherited IRA as having a net value equal to about 80% of its apparent value (assuming your effective tax rate is 20%).

Tax treatment follows an inherited IRA. If it was a Roth IRA before you inherited it, it's still a Roth IRA after you inherit it. Similarly, 401(k)s and traditional IRAs remain pre-tax accounts throughout the process.

Required Minimum Distributions

Required Minimum Distributions, or RMDs, are government-mandated withdrawals from tax-advantaged retirement accounts that begin when the account holder reaches 72 years of age. RMDs apply only to pre-tax accounts such as 401(k)s and traditional IRAs. Any mention of RMDs in the discussion that follows does not apply to after-tax accounts such as Roth IRAs.

Inherited IRAs

Some of the confusion surrounding inherited IRAs stems from the terminology. An inherited IRA is not necessarily an IRA in the conventional sense, it can be any type of tax-advantaged retirement plan such as a 401(k), traditional IRA, Roth IRA, 403(b), 457(b), TSP, SEP IRA, SIMPLE IRA, Solo 401(k), Roth 401(k), Roth 403(b), Roth 457(b), Roth TSP, or Solo Roth 401(k).

Another point of confusion is the name given to the account opened at a financial institution to receive an inherited IRA: it's called an Inherited IRA Account. You place an inherited IRA (retirement plan you inherited) into an Inherited IRA Account (account opened to receive an inherited IRA).

In cases where you cannot or choose not to take ownership of an inherited IRA, you are said to be treating yourself as the Beneficiary. You are already a beneficiary because you inherited something, but in this case, in inherited-IRA-vernacular, you are said to be treating yourself as the Beneficiary.

When devising a complicated system, it's always a good idea to use the same or similar terms to define different things (said no one ever). Thank you IRS.

Spousal Inherited IRA

If you receive an inherited IRA from your spouse, you have three options: you can designate yourself as the owner, roll it over into an existing IRA, or place it into an Inherited IRA Account.

If you designate yourself as the owner, you are allowed to make contributions to the account and RMDs are based on your age.

If you roll the inherited IRA into an existing IRA, you are allowed to make contributions to the account and RMDs are based on your age.

If you place the inherited IRA into an Inherited IRA Account (i.e., treat yourself as the Beneficiary), you are not allowed to make any contributions and RMDs depend on whether your spouse was receiving RMDs at the time of their death. If your spouse was not receiving RMDs (i.e., had not yet reached 72 years of age), RMDs begin in the year that your spouse would have turned 72. If your spouse was receiving RMDs, you must begin taking RMDs by December 31 of the year following your spouse's death. In either case, the RMD amount is based on your age.

Non-Spousal Inherited IRA

The rules surrounding inherited IRAs are more restrictive if you receive an inherited IRA from someone other than your spouse. You cannot designate yourself as the owner and you cannot roll it over into an existing IRA. You also cannot make any contributions. A non-spousal inherited IRA must be placed into an Inherited IRA Account.

If the inherited IRA is a pre-tax account such as a 401(k) or traditional IRA, it must be emptied within 10 years of the original owner's death. There are no conventional RMDs and no other restrictions on how the funds are distributed. If you are under 59.5 years of age, penalties for early withdrawal that would have otherwise been enforced are waived.

If the inherited IRA is an after-tax account such as a Roth IRA, it must be emptied within 5 years of the original owner's death. There are no other restrictions on how the funds are distributed.

Conclusion

While it might be tempting to take the money and run, with an inherited IRA that's usually not a good idea. If the inherited IRA is a pre-tax account and you drain it the first chance you get, you will likely bump yourself into a higher tax bracket. In the same scenario but with an after-tax account, you would rob yourself of 5 years of tax-free growth. That's the wonder of a Roth IRA, earnings grow tax-free and no taxes are due when the funds are distributed.

There are other ancillary rules that apply to inherited IRAs which were intentionally left out to simplify the discussion. There are time limits for certain actions to occur as well as other situations/relationships that qualify for the same treatment afforded to spouses. If you receive an inherited IRA, you should consult a financial advisor or at least read the details directly from the source: IRS.gov.

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