What Is an Inherited Individual Retirement Account (IRA)?

Inheriting an Individual Retirement Account (IRA) could come with some challenges. Different from other types of IRAs and retirement accounts, this retirement account comes with specific requirements. Understanding what an inherited IRA entails, including the rules and options available to beneficiaries, could help you make more informed decisions about opening an inherited IRA.

An “inherited IRA” is an account opened when an individual inherits an employer-sponsored retirement plan or individual retirement plan after the original account holder’s death. The beneficiary of an inherited IRA could be a spouse, relative, or unrelated party. There are no rules on who can inherit, but there are rules on how distributions are handled.¹ 

Inherited IRAs can be traditional IRAs or Roth IRAs, and the original account type determines the setup of the inherited IRA. For instance, if the original account is a Roth IRA, the inherited IRA must also be a Roth IRA.

When the owner of the IRA dies, the assets that are held in their account must typically be transferred into a new IRA that is in the beneficiary’s name. This then becomes an inherited IRA.²

Inherited IRAs are similar to any other IRA, with a few notable exceptions. One is that no additional contributions can be made to an inherited IRA. Spouses who inherit can roll the funds over into their personal IRA. Non-spouse inheritors need to withdraw the funds within ten years or take a lump-sum distribution which they may need to pay taxes on. 

Any type of IRA can be an inherited IRA. This includes traditional and Roth IRAs along with rollover IRAs, SEP-IRAs, and simple IRAs.³

The tax treatment of inherited IRAs differs depending on what type of IRA it was originally, and whether it was funded using pre-tax or post-tax dollars. 

If the original account holder died after 2019, the inherited IRA account holder must typically deplete the funds within ten years. Spouses can roll the funds over to another IRA to avoid this rule, and minor children who are direct descendants may also be exempt from this rule.⁴

Anyone who has inherited the assets of an IRA or employer-sponsored retirement plan is eligible to open an inherited IRA. That includes spouses, non-spouses, and any other beneficiaries. Eligible IRA types are traditional, rollover, SEP, SIMPLE, and Roth. The inherited IRA must match the type of original IRA. 

Spouses can roll over inherited IRAs into their existing retirement account if they want to. Non-spouse inheritors don’t have that option, but they can take a lump-sum distribution without incurring the normal 10% early withdrawal penalty. Standard income tax rates based on your overall gross income apply for traditional inherited IRAs. 

The options available to beneficiaries of an inherited IRA vary based on the age of the original account holder and the beneficiary’s relationship to the deceased. Non-spouse beneficiaries might need to take required minimum distributions (RMDs) based on the original account holder’s age. Spouses may be able to roll the funds over into their own IRA and use their normal RMD schedule with an IRA rollover.⁵

Choosing to use a rollover comes with advantages and disadvantages:

• Advantage of a Rollover: Rolling over to a personal IRA resets the RMD schedule.
• Disadvantage of a Rollover: Funds will be tied up until you start taking distributions.

Spouses can also convert to a Roth IRA with no RMDs to create tax-free retirement income. Though this also comes with advantages and disadvantages:

• Advantage of a Roth Conversion: Distributions will be tax-free in retirement.
• Disadvantage of a Roth Conversion: Income tax on your inherited IRA will be due this year.

Because non-spouse inheritors cannot make additional contributions to an inherited IRA, some choose to take a lump-sum distribution. There’s no early withdrawal penalty for doing this, but the inheritor will need to pay income tax on the funds if the original account is a traditional IRA or 401(k) funded with pre-tax contributions.⁶

Before choosing the early withdrawal, non-spouse inheritors should consider the following:

• Advantage of a Lump-Sum Distribution: You’ll get the money right away.
• Disadvantage of a Lump-Sum Distribution: The distribution amount is added to taxable gross income.

Another option is to disclaim the inheritance. There are several reasons to consider this. One is that you feel another party is more deserving of the funds. Another is that you don’t want to assume the tax liability for retirement funds that another individual saved.