Dave Ramsey: Here Are Your Options If You Are Inheriting an IRA
Written by
John Csiszar
Edited by
Gary Dudak
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Inheriting an IRA isn’t quite as simple as taking the money and going on your way. Since an IRA is a tax-advantaged vehicle, you’ll have to strategize how to maximize the value of the account without losing too big of a chunk in taxes. Additionally, there are specific rules as to how heirs must handle inherited IRAs, with spouses getting special treatment.
The bottom line is that there are only two real ways to handle an inherited IRA — or three if you are a spousal beneficiary — according to popular financial personality Dave Ramsey. According to a recent blog post on the Ramsey Solutions website, here are your options if you’re inheriting an IRA.
Take a Lump Sum
When you inherit an IRA, you have the right to take a full distribution and put the money directly in your pocket. Unfortunately, this is the least efficient way to handle such an inheritance.
For starters, you’ll pay tax on the entire amount of your inheritance. If you’re in the 22% tax bracket and you inherit an IRA worth $50,000, for example, you’ll owe $11,000 in taxes at the federal level alone, not to mention any possible state taxes. This drops your $50,000 inheritance to $39,000 or less. Even worse, depending on the size of the IRA and your own income, the distribution might be enough to boost you into a higher tax bracket.
In Ramsey’s view, taking a lump sum distribution isn’t usually the best course of action. However, he does advise that if you’re still paying off high-interest debt or building an emergency fund, which he refers to as “Baby Steps 2 or 3,” then it still might work in your financial best interest to take a lump-sum distribution. At least you can avoid the 10% early withdrawal penalty when taking a lump sum from an inherited IRA, even if you are under age 59.5, when the penalty would normally apply.
Open a Beneficiary IRA
The most tax-effective way to handle an inherited IRA is to open a beneficiary IRA. In this scenario, the IRA you inherit is transferred to a different IRA that lists you as the beneficiary. This shields you from the potentially big tax hit that taking a lump sum would generate. You can also keep the funds in the account and enjoy continued tax-deferred growth — at least, for a specified period of time according to IRS rules. For most beneficiaries, you’ll have to withdraw the money from the IRA within 10 years.
You won’t pay an early withdrawal penalty for taking the money out of a beneficiary IRA, but you will pay tax on all distributions, just as with any other traditional IRA. If you fail to get the money out in the required 10-year period, you’ll owe a stiff 50% penalty on the amount you were supposed to withdraw — and you’ll still have to pay tax on the money when you ultimately take it out.
If you inherit a Roth IRA, the same rules apply, but you won’t have to pay tax on any distributions.
Special Rules for Surviving Spouses
If you inherit an IRA as a spouse, you have some additional options for how to handle it. Probably the easiest and best way is to simply roll the money over into your existing IRA, or open a new IRA if you don’t already have one. In this way, the inherited IRA becomes yours completely, subject to the same contribution and withdrawal rules as if you always had the money in your own account.
In other words, you aren’t forced to withdraw the money until age 72, if a traditional IRA, and you can’t access it before age 59.5 without facing the 10% early withdrawal penalty.
Another special provision for spousal beneficiaries is that you can take distributions from the IRA over your life expectancy, as determined by IRS tables. For example, if you inherit a $200,000 IRA and the IRS says you have a life expectancy of 20 years, you’ll have to withdraw at least $10,000 in the first year. Every year after that, you’ll calculate your required distribution the same way, dividing the year-end account balance by your current life expectancy.
Of course, as a spousal beneficiary, you can still choose one of the options available to non-spousal beneficiaries, such as withdrawing the money over a 10-year period or all at once in a lump sum.
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