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Inheriting an IRA? Here's What You Need to Know

When a family member dies, the last thing on your mind is what to do with their old retirement accounts. But if you're the beneficiary, you'll have to make a decision at some point.

The wrong move could cost you a lot in taxes and penalties, so it's important to understand the rules surrounding inherited IRAs. Here are the most important things you need to know.

Inheriting from a spouse

Surviving spouses have two options when inheriting a traditional IRA: Remain a named beneficiary or add the assets to your existing retirement savings. Adding the money to your own account is the simpler solution of the two. You can either retitle the IRA so you're listed as the owner instead of your spouse, or you can transfer the funds to a separate IRA that you have already set up. So long as you transfer any distributions to a new account in your name within 60 days, you won't be taxed on the distribution, and the money can continue to grow tax-deferred in your account as if it had been yours all along.

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But this may not always be your best option. If you're under 59 1/2 and you transfer the money to your retirement account, you won't be able to touch it until you reach 59 1/2 unless you want to pay a 10% early-withdrawal penalty on top of income taxes, assuming it's a traditional IRA (as opposed to a Roth IRA). If you plan to use the money now, you're better off remaining a named beneficiary, in which case you'll be subject to the same rules as inheriting children, siblings, or other named beneficiaries. This enables you to take penalty-free withdrawals, though you still have to pay income tax if it's a traditional IRA. More on that below.

Inheriting from someone other than your spouse

If you're inheriting an IRA from a parent, sibling, other relative, or friend, the rules are more complicated. You're not allowed to transfer the assets from the inherited IRA into your own retirement account. Instead, you must make a new inherited IRA account in your name and transfer the funds to this account.

You can't make new contributions to this account, and you'll be required to take minimum distributions by Dec. 31 of the year following the original owner's death. For example, if the original owner dies in 2018, you must begin taking distributions from the inherited IRA no later than Dec. 31, 2019.

You have a few choices when it comes to how you want to take the distributions. The first option is a lump-sum payment. When you're taking the money from an inherited traditional IRA, you won't be charged a 10% early withdrawal penalty, even if you're under age 59 1/2, though you still will have to pay taxes on the money. The second option is a five-year distribution period. There won't be any required minimum distributions, but all the money will need to be withdrawn from the account by the end of five years.

The smartest distribution option for most people is the life expectancy method. If the original owner was older than you, then you use your own age and the IRS Single Life Expectancy Table (courtesy of Fidelity) to calculate how much you must withdraw from the account each year.

Look at the life expectancy factor next to your age and divide the total value of the IRA by that amount. If you're 40, for example, and your inherited IRA is worth $50,000, then you divide that amount by the 43.6 life expectancy factor for age 40. The result is $1,147, which is the amount you'll have to withdraw this year.

You can always take out more than the required minimum distribution (RMD), but if you fail to take out at least that amount, you'll be hit with a 50% penalty on the amount that was not withdrawn on time. So if you were supposed to take out $5,000 this year and you only took out $1,000, you'd pay a 50% tax on the remaining $4,000. That means $2,000 goes back into the government's pocket instead of your own.

Spouses also have the option to base their RMDs on the original owner's life expectancy instead of their own. This can be a smart move if your spouse was younger than you because it reduces the amount you're required to take out and allows the rest to continue accruing interest.

When there are multiple beneficiaries on an account, each must set up their own inherited IRA account and transfer the funds accordingly. RMDs will be based on each beneficiary's age. The exception is if the assets aren't separated by the Dec. 31 deadline. In that case, RMDs will be determined based on the oldest beneficiary's age until funds are distributed into each of the beneficiaries' inherited IRAs.

Special rules for Roth IRAs

Unlike traditional IRAs, Roth IRAs are not tax-deferred, so you don't need to pay any income tax when you withdraw funds. Roth IRAs also don't have RMDs for the original account owner. Surviving spouses inheriting Roth IRAs are also not required to take RMDs, provided they retitle the account or transfer the money to a Roth IRA of their own. But this is not the case for other named beneficiaries, who are required to take distributions from Roth IRAs using one of the three methods listed above. The difference is that if the money has been in the Roth IRA for more than five years, you won't have to pay any taxes on these distributions as you would with a traditional IRA.

The way you decide to handle your inherited IRA distributions can make a big difference in how long the money lasts and how much you end up paying in taxes. Think through all of your options carefully and run the numbers to figure out which distribution schedule is right for you.

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