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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 If the IRA includes an after-tax balance, then this portion is not taxable when withdrawn.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, transfer it into an inherited IRA in your name or do a combination of the two.

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.

If you're inheriting an IRA from a parent, you are considered a designated beneficiary, unless one of the following applies (in which which you'd be considered an eligible designated beneficiary):

  • 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

If a minor child inherits the account, they will be considered an eligible designated beneficiary until they reach the age of majority.

Distribution methods available have specific rules based upon the date of death and type of beneficiary:

Nonspouse beneficiaries will be subject to distribution rules. The time period and withdrawal method depends on the year of death of the IRA owner and whether the beneficiary is considered a designated or eligible designated beneficiary. Talk to your financial advisor about details applicable to your situation.

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.

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.