When the owner of an IRA passes away, the IRA is classified as an “inherited IRA,” and the benefits pass to the beneficiary or beneficiaries. A “designated” beneficiary is one whom the IRA owner has listed on a beneficiary form, generally on file with the IRA’s custodian. If no beneficiary has been designated, then the IRA’s custodian will determine the beneficiary according to its firm rules and additional distribution rules apply.

IRA Beneficiary Rules
The beneficiary must follow fairly complicated rules regarding the subsequent treatment of the IRA and required minimum distributions (RMD). Distributions that would have been taxable to the original owner will be taxable to the beneficiary when they are paid.  The following is an overview of the basic rules regarding traditional IRA’s only (Roth IRA rules may differ) and you should consult with your tax advisor before taking any distributions from the inherited IRA.

Surviving Spouse Beneficiary
If you are the surviving spouse of the deceased, you can elect to treat the inherited IRA as your own. However, in order to make that election, you must be the only beneficiary of the IRA and have the unlimited right to withdraw amounts from it. Treating the IRA as your own gives you the right to name yourself as the account owner and/or roll the inherited IRA over into your own IRA

If the IRA is a traditional IRA and the owner died before reaching age 70 1/2, you will not be required to take any distributions until you reach age 70 1/2 and they will be based on your life expectancy. If the decedent would have been required to take an RMD in the year of death, but did not, you must take it in the decedent’s place.  The RMD, if any, in the year of death is determined as if decedent survived for an entire year.  If electing to treat the IRA as your own, RMDs in future years will be based on your life expectancy.

When you elect to treat the IRA as your own, distributions taken prior to reaching age 59 1/2 are subject to the 10% penalty for early withdrawal.  If you are a surviving spouse under age 59 1/2 and feel you will need to take distributions sooner, you may wish not to elect surviving spouse treatment and follow the rules applicable to non-spouse beneficiaries.  However, if you fail to take an RMD under the non-spouse rules, the IRA will be deemed as now owned by you as surviving spouse under IRS rules.

Non-spouse Beneficiary
If you are not the surviving spouse, you have fewer options.  If you would like to move the IRA to a different custodian, a direct rollover, that is a transfer directly from one custodian to the other is preferred, and the funds must be deposited into a new IRA in the name of the deceased for your benefit.  You cannot contribute additional money to the inherited IRA or roll it into an existing IRA of your own.

You can choose to take a distribution of the entire IRA in one lump sum but the portion, possibly all, which would have been taxable to the deceased will be taxable to you in the year of the distribution. If you are under age 59 1/2, no penalty will be charged.

Alternatively, you can choose to take your distributions as RMDs. If the IRA is a traditional IRA and the owner died before reaching age 70 1/2, your RMD is based on your single life expectancy using tables issued by the IRS.  Generally, RMDs must start by the end of the year following the year of death.  If the date of death falls on or after the required start of RMDs and the decedent did not take an RMD during that year, you must take it in the decedent’s place.  The RMD, if any, in the year of death is determined as if decedent survived for an entire year.  For years following the year of death, your RMD will be computed based on your single life expectancy or the original owner’s life expectancy, whichever is longer.

Distributions required, but not taken, may be subject to a 50% excise tax.  If no beneficiary is designated or the beneficiary is not an individual, an additional 5-year rule may apply.

You should always consult with your tax advisor before taking any distributions from the inherited IRA.