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How to navigate inheriting an IRA from a parent

Daughter embracing senior mother after outdoor family dinner party
Thomas Barwick/Getty Images

Many parents want to make sure their children are set financially after they are gone. But when you've lost a parent, the last thing on your mind is figuring out the rules and options for what they've passed on to you.

If you've inherited an individual retirement account (IRA) from your parent, there's a lot to understand. It might seem impossible to learn the rules and impacts while you're grieving, but this breakdown provides you with the information you need to make the best decision for your situation.

Understanding the taxes on inherited IRA from parent

The first thing you're likely to wonder is how you'll be taxed on an inherited IRA. The answer depends on the type of IRA it is and what you choose to do with it:

  • Roth IRA. Qualified distributions from Roth IRAs are not taxable. This includes inherited Roth IRAs. However, the five-year rule still applies: If less than five years have passed since the first Roth contribution was made, then the earnings are taxable.
  • Traditional IRA. With this type of IRA, distributions are included in your income and taxed accordingly. If the IRA includes an after-tax balance, then this portion is not taxable when withdrawn. There is no early withdrawal penalty no matter your age.

What are your distribution options?

As a nonspouse beneficiary inheriting an IRA from a parent, you have two options: You either can withdraw the account as a lump sum or transfer it into an inherited IRA in your name.

1. Lump-sum distributions

If you withdraw the balance as a lump sum, then you'll owe taxes on the entire taxable portion in the year you take the withdrawal.

While a windfall of funds can be helpful after a parent passes, this is often the least beneficial option because you lose the benefit of any further tax deferral. Also, the distribution may increase your taxable income to a level that will put you in a higher tax bracket.

2. Establish your own inherited IRA

To transfer the money into an inherited IRA, you'll first need to open an inherited IRA by working with a financial firm, like Thrivent, that offers this type of account. You will be required to complete account paperwork that includes instructions for transferring the money into your new account.

It's important to fill out this paperwork correctly. Make sure you are selecting the correct account and transfer type. As a nonspouse beneficiary, you must transfer the IRA directly into an account titled in your parent's name for your benefit as 60-day indirect rollovers are not available. Otherwise, the IRS treats the transfer as a distribution, and you must include the taxable portion in your income.

Establishing an inherited IRA is often the most advantageous option from a tax perspective because you still can allow the account to grow tax-deferred and spread your distributions over multiple tax years. However, as a nonspouse beneficiary, an inherited IRA does not provide you with protection from creditors in the event of bankruptcy.

Distributions from an inherited IRA

Different sets of rules may apply to you depending on the original account owner's date of death and whether you are considered a designated beneficiary or an eligible designated beneficiary.

designated beneficiary is a person named as the beneficiary on the account, other than an eligible designated beneficiary.

An eligible designated beneficiary is defined as:

  • Minor children of the original owner
  • People who are chronically ill
  • People who are permanently disabled
  • People who are less than 10 years younger than the original owner

In addition to designated and eligible designated beneficiaries, there is a nondesignated category. Nondesignated beneficiaries are entities like an organization, charity or trust. Nondesignated beneficiaries must withdraw the account within five years.

Distribution methods available to designated beneficiaries have specific rules based upon the date of death:

If your parent passed before January 1, 2020:

You need to consider whether they had reached their beginning date for taking required minimum distributions (RMDs). It's the minimum amount you are required to withdraw from an IRA. Failure to take an RMD when required incurs a penalty. You also can choose to withdraw more than the RMD if you want to.

The date at which you must begin taking RMDs is typically the year you turn 70½. As such, take the following into consideration for an inherited IRA:

  • If your parent did not reach their required beginning date, then you must either:

    • Begin taking RMDs by December 31 of the year following their death. The RMD is then based on your own life expectancy.
    • Withdraw the entire balance by December 31 of the fifth year after the original owner's death.
  • If your parent did reach their required beginning date before passing, then you must begin taking RMDs by December 31 of the year following the original owner's death based on your own life expectancy.

If your parent passed on or after January 1, 2020:

The SECURE Act of 2019 requires that most nonspouse designated IRA beneficiaries withdraw the entire balance of an inherited IRA within 10 years of the original owner's death.

Note that there are pending changes in the SECURE Act 2.0, so keep an eye out for updates that impact nonspouse beneficiary rules.

Distribution methods available to eligible designated beneficiaries include:

Certain exceptions to the above distribution rules are available to eligible designated beneficiaries.

  • Beneficiaries who are less than 10 years younger than the original owner, disabled or chronically ill can take distributions based on their own life expectancy.

    Note: If there are multiple beneficiaries, the IRA must be split and transferred to an inherited IRA in each beneficiary's name in order for each beneficiary to base distributions on their own life expectancy.

  • Minor children may take distributions based on their own life expectancy until they reach the age of majority. Once they reach the age of majority, they have 10 years to withdraw the remaining balance.

In addition to designated and eligible designated beneficiaries, there is a nondesignated category. Nondesignated beneficiaries are entities like an organization, charity or trust. Nondesignated beneficiaries must withdraw the account within five years.

Get help after inheriting an IRA from a parent

Inheriting a retirement savings account from a parent can be difficult to navigate as you prepare to move forward without them. The first step in making the right financial decision is to learn the options you have and the rules to follow when your decreased parent passes on an IRA to you.

The next step should be connecting with a financial advisor to better understand the ins and outs of inheriting IRAs from a parent. An advisor can help you determine which option will work best for your situation and help you take the right actions to create a strong financial future.

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Distributions of earnings are tax-free as long as your Roth IRA is at least five years old and one of the following requirements is met: (1) you are at least age 59½; (2) you are disabled; (3) you are purchasing your first home ($10,000 lifetime maximum); or (4) the money is being paid to a beneficiary.

Thrivent and its financial advisors and professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.