How Inherited IRAs Work

The idea behind an IRA is fairly simple. You put tax-deferred money into the account where it grows, tax-free, until you retire. Then, when you start taking money out, it becomes taxable income. Behind the apparent simplicity, however, is a web of rules that can trip up unwary IRA owners. Among the more complex regulations are those that deal with inherited IRAs.

If the person who inherits the IRA is the spouse of the owner, things stay fairly simple. The surviving spouse can treat the IRA as if it were his/her own, taking distributions, or rolling over assets into another IRA, for example. When the beneficiary of the IRA is not the spouse of the owner, things get trickier. The beneficiary must keep the assets in the IRA apart from any other accounts he/she may have and cannot defer withdrawals, but must start taking money out of the account right away, based on his/her life expectancy. A beneficiary whose life expectancy is 20 years, for example, must take out 5% of the total assets in the IRA every year. If the owner did not name a beneficiary, the tax situation can be grim, since the assets go into the estate, and a beneficiary who is not a spouse must liquidate the entire account within five years.

Not naming an IRA beneficiary can make a huge difference in what your heirs actually get. An heir who is forced to withdraw 20% of the assets in an IRA every year could get pushed into a higher tax bracket, resulting in a tax of as much as $165,000 on a $500,000 IRA. In comparison, a beneficiary who can spread withdrawals over a longer time period could see hefty tax savings.