What to do with an inherited IRA

If you've inherited IRA assets or are involved in estate planning, it's important to understand the different rules that may apply to your situation depending on a variety of factors. Being familiar with the complexities of managing an inherited IRA can help you maximize its benefits and minimize taxes.

Some key distinctions between the 3 types of inherited accounts:

• Spousal inherited IRA: When a spouse inherits an IRA, they have more flexibility in how they manage it. They can choose to remain the beneficiary of the inherited IRA or to assume ownership by transferring the proceeds to their own IRA. This allows for continued tax deferral, and the usual rules concerning distributions apply based on the age of the surviving spouse if the surviving spouse elects to treat the proceeds as their own. The required minimum distribution (RMD) factor and the timing of when RMDs begin can vary. RMDs from the inherited IRA can be deferred until the spouse would have been RMD age, while an assumed IRA would use the surviving spouse's RMD age. 
  
  It should be noted that different rules apply if the spouse wishes to remain the beneficiary (common if the surviving spouse is under 59½ and wishes to avoid the 10% early withdrawal penalty).
  
• Nonspousal inherited IRA: Nonspouse beneficiaries, such as children or friends, cannot treat the inherited IRA as their own. This means they can't make additional contributions to the IRA. They're generally required to take distributions from the account, which are subject to different rules depending on the original owner's age at death and the beneficiary's own age. Recent changes under the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 have modified the distribution requirements, generally requiring nonspouse beneficiaries to withdraw all assets from an inherited IRA within 10 years after the death of the original owner, unless they qualify as an eligible designated beneficiary. RMD requirements may apply within the 10-year period as well.
•  Non-person inherited IRA: In rare instances, retirement accounts might be left to a non-designated beneficiary. This term refers to an entity like a charity, estate, and even certain trusts. The rules associated with these beneficiaries remain largely unaffected by the SECURE Act, as the distribution options are based on whether the owner died before reaching their required beginning date. If the owner died before this date, the inherited account must be liquidated at the end of the fifth year after the owner's death (but there are no annual RMDs); if death occurred on or after this date, then the inherited IRA can be “stretched” using the owner's "ghost" life expectancy—information obtained from the single life expectancy table—to calculate the annual required minimum distribution.¹

Understanding the type of inherited IRA and the rules associated with it is crucial for managing the account properly and avoiding potential tax pitfalls.

How to calculate RMDs for inherited IRAs

RMDs are mandatory, annual withdrawals that must be taken from certain types of retirement accounts once the account holder reaches a specific age. This age was traditionally 70½ but was raised to 72 following the passage of the SECURE Act in 2019. Further, beginning in 2023, the SECURE Act of 2022 (SECURE 2.0) raised the required age for taking RMDs to 73. RMDs apply to various types of accounts, including traditional IRAs, 401(k)s, and other tax-deferred retirement plans.

Since IRA contributions often receive upfront tax benefits—meaning taxes are deferred until money is withdrawn—RMDs guarantee that the government can collect taxes on these funds during the account holder's lifetime. This ensures that these accounts aren't used as a tool to accumulate wealth indefinitely.

If you inherit an IRA, you'll need to set up an IRA beneficiary distribution account (BDA) with a financial institution to receive and manage the inherited IRA assets according to IRS regulations.

The RMD rules for inherited IRAs vary depending on the relationship of the beneficiary to the original account holder and when the account holder passed away. If you're a beneficiary, it's crucial to understand and follow these rules in order avoid potential penalties. Our inherited RMD calculator is a helpful tool to get started.

For deaths before 2020: If the original IRA owner died before January 1, 2020, beneficiaries could often extend the distributions over their own life expectancies. This method, commonly referred to as the "stretch IRA" strategy, allowed beneficiaries to take smaller RMDs based on their initial life expectancy, potentially deferring taxes and allowing the investments more time to grow.

For nonspouse beneficiaries, the RMD amount is calculated each year based on the account balance at the end of the previous year divided by a life expectancy factor from the IRS Single Life Expectancy Table. This factor decreases each year, reflecting a shorter remaining life expectancy. For example, the beneficiary would use their age in the year after death to determine this figure, then subtract 1 for each subsequent year (spouses could recalculate annually, but everyone else uses the "minus 1" rule for each passing year).

For deaths in 2020 and later: Under the SECURE Act, if the original IRA owner died on or after January 1, 2020, the rules changed significantly for most nonspouse beneficiaries. These beneficiaries are generally required to withdraw the entire balance of the inherited IRA by the end of the 10th year following the year of inheritance. RMD requirements may apply within the 10-year period as well. This rule eliminates the possibility of stretching distributions over the life expectancy of the beneficiary.

Exceptions: Certain beneficiaries, referred to as "eligible designated beneficiaries," are exempt from the 10-year rule and can still take distributions over their life expectancy. These include:

• Spouses.
• Minor children of the original IRA owner (until they reach age 21; the 10-year rule applies thereafter).
• Disabled individuals.
• Chronically ill individuals.
• Individuals not more than 10 years younger than the IRA owner.

Spousal beneficiaries: Spouses who inherit an IRA have more flexible options. They can:

• Treat the IRA as their own, which means the RMD rules that apply to their own age and life expectancy will apply.
• Continue the IRA as an inherited IRA, with the surviving spouse taking RMDs based on their life expectancy.

For inherited IRAs, especially those inherited from owners who passed away in 2020 or later, it's important for beneficiaries to understand these new RMD rules to manage their tax obligations effectively and plan their financial strategies accordingly.

Are inherited IRAs taxable?

The tax implications of inherited IRAs can vary depending on the type of IRA inherited (traditional or Roth), the relationship of the beneficiary to the original account holder, and the distribution method chosen. Understanding when taxes are due and how they are calculated is crucial for beneficiaries to manage their tax liabilities effectively.

Let's look at some specific IRA distribution rules and considerations.

Traditional inherited IRAs: With these accounts, distributions are generally taxable as ordinary income at the beneficiary's current income tax rate. Since the funds in a traditional IRA are contributed pre-tax, all withdrawals are subject to income tax. However, the 10% early withdrawal tax does not apply to inherited IRAs, even if the beneficiary is under the age of 59½.

Taxes are due in the year each distribution is taken. For example, if a beneficiary takes a distribution in 2023, the income from that distribution must be reported on their 2023 tax return, and any tax due would be paid during the tax filing season in early 2024. Calculating the tax involves adding the distribution amount to the beneficiary's other income for the year and applying their marginal tax rate. Also, the original owner's basis for nondeductible contributions carries over to the inherited IRA and may reduce the tax owed on distributions. Please consult a qualified tax professional for assistance with your tax returns.

Inherited Roth IRAs: If a Roth IRA has been held for at least 5 years before the original owner's death, distributions are generally tax-free. This is because contributions to a Roth IRA are made with after-tax dollars, and any growth within the account is tax-free once the 5-year holding period has passed.

If the Roth IRA was established less than 5 years before the owner's death, the earnings from distributions might still be taxable until the 5-year threshold is met based on the original account's initiation date. However, the principal (contributions) remains tax-free upon withdrawal. For instance, if an owner started a Roth IRA in 2022 and passed away in 2024, the 5-year period would be reached by 2027, allowing tax-free withdrawals of earnings thereafter.

State taxes: In addition to federal taxes, state income taxes may apply to IRA distributions, depending on the state in which the beneficiary lives.

Penalties: Failing to take required distributions results in a penalty tax on the amount that should have been distributed but was not. SECURE 2.0 reduced the excise tax rate to 25%; possibly 10% if the RMD is corrected within 2 years. Given the penalty, it's important for beneficiaries to understand and comply with RMD rules.

Explore Vanguard's tax center for more guidance and details.

Rules for inherited IRAs

Inherited IRAs come with specific rules that vary depending on whether the beneficiary is a spouse or a nonspouse, and whether the nonspouse qualifies as an eligible designated beneficiary. Understanding these rules is crucial for managing the inherited assets effectively and avoiding penalties. It should be noted that the following information concerns IRAs inherited after 2019.

Spousal beneficiaries: Spouses who inherit IRAs have flexible options. They can:

• Treat the IRA as their own: By either transferring the assets into their existing IRA or retitling the inherited IRA in their name. This allows the spouse to manage the account as if they were the original owner, including the timing of distributions (based on their own age) and the continuation of tax-deferred growth in the case of a traditional IRA.
• Transfer into an inherited IRA: This option generally involves taking RMDs based on the deceased spouse's required beginning date.  However, RMD amounts are based on the surviving spouse's life expectancy using either the single life table or the uniform life table as applicable. The surviving spouse can also choose to inherit the IRA, and then treat it as their own later.  However, once the decision to treat is as their own is made, it cannot be reversed.

Nonspousal beneficiaries: Nonspouse beneficiaries cannot treat the IRA as their own. They must transfer the assets into an inherited IRA and:

• Withdraw the entire account within 10 years: For deaths after 2019, most nonspouse beneficiaries are required to withdraw all assets from the inherited IRA within 10 years of the original owner's death.  It may be necessary to take RMDs during those 10 years, but the account must be fully distributed by the end of the 10th year.
• Take distributions based on their life expectancy: This option is available to certain eligible designated beneficiaries, such as minor children of the original IRA owner (until age 21, regardless of the age of majority of individual states, at which point the 10-year rule applies), disabled individuals, and individuals not more than 10 years younger than the IRA owner.

Other rules to note:

The complexities of inherited IRAs and how the decedent's death date influences the RMDs should be carefully explored if this situation applies to you. Whether you're a spouse, a nonspouse, or a non-designated beneficiary, the rules vary significantly. To learn more about navigating these rules, read our article on RMD rules for inherited IRAs.

10-year rule for non-eligible designated beneficiaries: Under the SECURE Act, most nonspouse beneficiaries of IRAs inherited from owners who died after 2019 must withdraw the entire account balance within 10 years of the owner's death. Final regulations have confirmed that if the owner died on/after their required beginning date, the non-eligible designated beneficiary must take annual RMDs, in addition to closing the account no later than the end of the 10th year after death. (Please note this only applies to traditional IRAs.) Beneficiaries have the flexibility to time their distributions for tax planning purposes, such as spreading out distributions to avoid higher tax brackets in any given year.

Life expectancy rule: Also known as the "stretch" option, this rule allows certain eligible designated beneficiaries—such as a spouse, a minor child of the IRA owner, a disabled or chronically ill individual, or someone not more than 10 years younger than the IRA owner—to take distributions over their own life expectancy. The life expectancy rule only goes to age 21, then the 10-year rule begins. This method involves calculating annual RMDs based on the beneficiary's life expectancy, starting the year after the IRA owner's death. These distributions are typically smaller, allowing the remaining balance to continue growing tax-deferred, or tax-free in the case of a Roth IRA.

Beneficiaries should carefully review their options and consider talking with a financial advisor to avoid penalties and optimize their tax situation.

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Can an inherited IRA be converted to a Roth IRA?

Converting an inherited IRA to a Roth IRA, known as a Roth conversion, involves moving pre-tax retirement funds into a Roth account, which can offer significant long-term tax benefits. But the rules and feasibility of doing this depend heavily on the relationship of the beneficiary to the original IRA owner.

Conditions for conversion: For spouse beneficiaries, the process is relatively straightforward. A spouse can roll over the inherited IRA assets into their own IRA and then convert that into a Roth IRA. This is allowed because spouses have the unique ability to treat inherited IRAs as their own.

Under current IRS regulations, nonspouse beneficiaries cannot directly convert an inherited traditional IRA into an inherited Roth IRA. They can distribute the funds, pay the necessary taxes, and then potentially invest those funds into a Roth IRA they already own, subject to annual contribution limits—which may not accommodate the full amount of the inherited IRA immediately. However, nonspouse beneficiaries may still enjoy the benefit of conversion—with one caveat. They can only convert an inherited employer plan.

Benefits of converting to a Roth IRA: The primary advantage of converting to a Roth IRA is the tax-free growth and withdrawal benefits. Unlike traditional IRAs, Roth IRAs don't require minimum distributions during the beneficiary's lifetime, and qualified withdrawals are tax-free. This can be a big advantage for beneficiaries who expect to be in a higher tax bracket in the future or those who wish to avoid RMDs to let their account grow tax-free for as long as possible.

Potential drawbacks: The major drawback of converting to a Roth IRA is the immediate tax liability. The converted amount is treated as taxable income in the year of the conversion. This can result in a significant tax bill, potentially pushing the beneficiary into a higher tax bracket.

Continued growth potential

An inherited IRA holds significant potential for continued growth and long-term financial benefits, primarily due to its tax-advantaged status.

Beneficiaries should familiarize themselves with the range of investment options available within the inherited IRA. These might include stocks, bonds, mutual funds, ETFs (exchange-traded funds), and possibly other assets. Each type of investment carries its own risk and return profile, and understanding these can help in making decisions that best fit the beneficiary's financial strategy.

Younger beneficiaries who can afford to wait longer before taking distributions might opt for growth-oriented investments, such as stocks or aggressive mutual funds, which typically offer higher returns at a higher risk. Those needing to withdraw funds sooner might prefer more conservative investments, such as bonds or stable value funds, to help preserve capital. Diversifying the investment portfolio within the inherited IRA can reduce risk and improve potential returns.

Maximizing the value of an inherited IRA through careful investment choices involves a strategic approach that aligns with the beneficiary's financial goals, risk tolerance, and the distribution requirements of the IRA.

IRAs and inherited IRAs for minors

Technically, every Vanguard IRA® is a custodial account with Vanguard as the custodian per The IRA Disclosure Statement and Custodial Account Agreement. However, for the purposes of this article, an individual retirement account managed by a custodian on behalf of a minor until they reach adulthood will be referred to as a custodial account. When a minor inherits an IRA, it's typically transferred to a custodial inherited IRA, where a guardian oversees the account until the minor beneficiary comes of age. Only the minor child of the owner is considered an eligible designated beneficiary (EDB)—other relations, like grandchildren, nieces, nephews, etc., do not count.

For IRAs inherited by minors who are also eligible designated beneficiaries (EDBs), the SECURE Act mandates that distributions are made based on the initial life expectancy of the child (starting the year after parent's death), reduced by 1 for each subsequent year. At 21, the 10-year window starts and annual RMDs continue.² At the end of the year when the child turns 31, the account must be closed.

This gives the investments more time to grow, maximizing the financial benefits while ensuring compliance with tax rules and regulations.

Benefits comparison

Inherited IRAs are particularly helpful for beneficiaries who have received assets from a deceased IRA holder, providing a means to manage and access these funds while potentially stretching the tax-deferred status over a decade. For beneficiaries who may need to supplement their income or manage large, immediate financial needs following the death of the original account holder this can be a major benefit.

Custodial IRAs are ideal for minors as they offer a structured way to build savings and invest over time while under the guidance of a custodian. This type of account helps to foster financial literacy from an early age and prepare for significant future expenses like education or a first home purchase.