You've Inherited an IRA—Now What?

Dear Carrie,

I recently inherited a traditional IRA from my father. Can I cash out just some of the money if I need it, or do I have to take it all out now?  

—A Reader

Dear Reader,

I’m sorry to hear of your loss. As I’m sure you know, an inheritance can bring up conflicting emotions, placing the positive of financial gain against the sadness of losing a loved one.

Complicating the situation further, certain inheritances—such as an IRA—are more difficult to sort out than others. In addition, changes under the SECURE Act passed in 2019 mean new options beginning in 2020. A beneficiary’s relationship to the deceased and when he or she inherited the IRA will determine exactly what those options are.

Spouse versus non-spouse beneficiaries

The first thing to understand is that IRA inheritance rules differ depending on whether the beneficiary is a spouse or non-spouse. A spouse has almost limitless options, including treating an inherited IRA as his or her own, even to the extent of converting it to a Roth.

A non-spouse beneficiary like yourself, however, generally has much more limited choices. As a non-spouse, you can either take the IRA money in a lump sum or, in some cases, as required minimum distributions (or a combination of both).

Required minimum distributions for inherited assets before 2020

For retirement accounts inherited by a non-spouse before 2020, the proceeds can be distributed over your lifetime (often referred to as “stretch IRAs”). Taking mandatory withdrawals over time can ease your tax burden, but the process is a bit more complicated than taking a lump sum.

The first thing you have to do is open an inherited IRA in the name of the original account holder for your benefit. Just like the original account holder, you won't be taxed on the assets until you take a distribution, so your tax hit is spread out. There is no 10 percent penalty for early withdrawals.

After that, you may have one more choice to make depending on your father’s age when he passed away. Here, in a nutshell, are your options:

If your father was under 70½ when he died, you have two options for taking distributions:

1. The Life Expectancy method, in which you must take an annual required minimum distribution (RMD) spread over your own life expectancy, based on IRS life-expectancy tables and determined by your age in the calendar year following the year of your father’s death. Distributions must begin no later than December 31 of the year after the year of death, and will be reevaluated each year. Of course, you can always take more than the RMD if you wish.
2. The Five-Year method, which allows you to take distributions of any amount at any time up until December 31 of the fifth year after the year your father died, at which time all assets must be fully distributed.

If your father was over 70½, you must use method number one, the Life Expectancy method. The five-year option doesn't apply. And one more thing: with the Life Expectancy method, if your father didn't take an RMD in the year of his death, you must take an RMD by December 31 of that year.

Note that the new rules under the SECURE Act do not affect existing inherited accounts. They only apply to accounts that are inherited in 2020 and beyond.

Required minimum distributions for inherited assets after 2020

Under the new SECURE Act, retirement assets must be distributed within ten years if the IRA owner died on or after January 1, 2020. In other words, you can take all or part or none any given year, as long as it’s all distributed by 10 years. However, there are exceptions for spouses, minor children, disabled individuals and persons less than ten years younger than the decedent. These individuals—sometimes referred to as ‘eligible designated beneficiaries’—can still withdraw or “stretch” out funds on the basis of life expectancy allowing them to defer distributions from inherited retirement accounts for a longer period of time. (Once minors reach the age of majority he or she will need to distribute the entire account within 10 years.) The age of the decedent when he or she died doesn’t matter.

If you take the assets as a lump sum

As I mentioned, as a non-spouse, you can take the assets all at once. The upside is that you have access to all the money right away, and there's no 10 percent penalty for early withdrawals. The downside is that you'll have to pay income tax on the distribution at your ordinary income tax rate, which could be quite a sum depending on the amount of the inheritance.

Another concern is that the distribution itself could bump you into a higher tax bracket, increasing the amount of taxes you have to pay. Therefore, a lump sum may not be the most tax- efficient way to access the assets.

Looking at the positive

As you can see, there's a lot to think about. I suggest talking to your tax advisor before making a choice. You could also consult IRS Publication 590, which goes into greater detail on all aspects of IRA withdrawals.

While the rules are complex, taking mandatory withdrawals under even an accelerated ten-year time table does have its benefits. For one, the undistributed assets can keep growing tax-deferred—which can be a significant boost over time. This choice also allows you to manage the assets according to your own goals and time horizon.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.

Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)