What Every Spouse Needs to Know About Inheriting an IRA

Many mistakes are made with inherited individual retirement accounts (IRAs). The rules aren’t straightforward or intuitive, so people often make the wrong decisions, resulting in thousands of dollars of taxes unnecessarily paid to the Internal Revenue Service (IRS). Your loved ones need to know what to do when they inherit an IRA.

Knowing the rules is especially important for spouses. Most IRAs name the spouse as the primary beneficiary. A surviving spouse has more options than other IRA beneficiaries. That provides more opportunities to maximize the after-tax value of the IRA but also increases the potential for choosing a bad option.

A surviving spouse who is named the beneficiary of his or her deceased spouse’s traditional IRA has the same options any other IRA beneficiary has. But there’s a twist to one of them, and the surviving spouse has an additional option.

• One option is to distribute all of the IRA assets within five years of the original IRA owner’s death. Of course, that eliminates the potential for tax-deferred compounding of the IRA. All the distributions will be included in gross income and taxed in the same way they would have been to the original owner. That’s the least attractive tax option but might be considered when the cash is needed. One positive aspect of this option is that the 10% tax on distributions made before age 59½ doesn’t apply to distributions from Inherited IRAs. The penalty won’t be imposed, regardless of how young the surviving spouse is.

• The second option is to establish an inherited IRA. This involves changing the title of the IRA to reflect that it is an inherited IRA held for the benefit of the surviving spouse. Each IRA custodian uses its own particular wording, but the title of an inherited IRA typically is similar to this: Max Profits, deceased, IRA FBO Rosie Profits. “FBO” means “for the benefit of.”

Here’s one area where the rules are a little different for a surviving spouse. When non-spouse beneficiaries establish an inherited IRA, they are required to begin required minimum distributions (RMDs) by Dec. 31 of the year following the original IRA owner’s death. No matter how young the beneficiary is, required distributions must begin and can be based on the beneficiary’s life expectancy.

The rule’s the same for a surviving spouse if the deceased spouse already reached the age for RMDs. But the surviving spouse has an option when the other spouse passed away before reaching RMD age. The surviving spouse doesn’t have to begin RMDs from the inherited IRA until after the deceased spouse would have been age 70½. When the RMDs begin, they are based on the surviving spouse’s life expectancy, not the deceased spouse’s unless the surviving spouse wants to use the deceased spouse’s age. Yet, the surviving spouse is permitted to take distributions from the IRA whenever money is needed before the RMDs begin. The distributions will be taxed the same as they would have been for the original owner, but because this is an inherited IRA the 10% early distribution penalty doesn’t apply.

The options above are available only if the surviving spouse is the sole primary beneficiary of the IRA. If others share as primary beneficiaries, then all are treated as non-spousal beneficiaries.

• The third option, and one that’s unique for surviving spouses, is the spousal rollover, or fresh start, IRA. The surviving spouse can use this option for his or her share of an IRA even when there are other primary beneficiaries. Under this option, the surviving spouse moves the assets to his or her own IRA. The move can be done by the IRA custodians, or the surviving spouse can take a distribution and deposit that amount into his or her own IRA within 60 days. The spousal IRA can be a new IRA set up for this purpose or an existing IRA. The assets also can be moved tax-free to any other qualified retirement plan, such as a 401(k) account.

Once a spousal IRA is created, it is treated as though it always were the surviving spouse’s IRA. No reference is made again to the inherited IRA. The surviving spouse names new beneficiaries. The RMD schedule is determined solely by the surviving spouse’s age, not by the deceased spouse’s age. That’s why it’s also called a fresh start IRA.

• A fourth option is very similar to the third option. The surviving spouse simply treats the inherited IRA as his or her own IRA. This has the same effects as the spousal IRA, but it rarely is done this way. Usually, the spousal rollover is used. That avoids any misunderstanding about the surviving spouse’s intentions.

Once executed, a spousal rollover is irrevocable.

The best option for the surviving spouse usually depends primarily on the spouse’s age. Here’s why. When the surviving spouse is under age 59½, the 10% penalty on early distributions applies to any money taken from a spousal rollover IRA. Remember that after a spousal rollover, the IRA is treated exactly as any IRA owned by a surviving spouse without reference to the inherited IRA. That means any distributions before age 59½ are included in gross income and subject to the 10% early distribution penalty, unless the spouse qualifies for one of the exceptions to the penalty other than that the assets were inherited.

But the 10% early distribution doesn’t apply to any distributions from an inherited IRA. If the surviving spouse is less than age 59½ and might need to take a distribution some time before that age, then the inherited IRA likely is the best option. When the surviving spouse is older than age 59½, then the spousal rollover is the preferred option.

Another benefit of the inherited IRA option is that a spousal rollover always can be executed later without penalty. So, a younger spouse can select the inherited IRA option first, and then do the spousal rollover after turning age 59½ or at any other time.

The choice is more difficult when the surviving spouse was substantially younger than the deceased spouse. In that case, under the inherited IRA, the surviving spouse might be forced to begin RMDs at an early age, even before turning age 59½, depending on the age difference between the spouses. Yet, the RMDs at that point are likely to be fairly low. It might be worth the cost of the RMDs to preserve the ability to take a larger penalty-free distribution at any time in case the cash is needed.

The effects on the next generation of beneficiaries also should be considered.

When the surviving spouse chooses the inherited IRA option and passes away before starting RMDs, then the next generation of beneficiaries must begin RMDs by the end of the year following the surviving spouse’s death, but they can use their own life expectancies to compute those RMDs. When the surviving spouse was taking RMDs because the first deceased spouse would have reached age 70½, then the next generation of beneficiaries must continue the distribution schedule the surviving spouse was using.

When the spousal rollover was used, the rules are similar. If the surviving spouse hadn’t begun RMDs at the time of his or her death, then the next generation of beneficiaries must begin RMDs by Dec. 31 of the following year and can use the spouse’s life expectancies. If the surviving spouse had begun RMDs, then the next generation has the option of taking the RMDs using either their own life expectancies or using the distribution schedule established by the surviving spouse’s life expectancy.

There’s one other angle to consider. I regularly advise people not to name their estates as IRA beneficiaries or not to fail to name an IRA beneficiary. That’s because the potential for deferral is lost when an entity other than a natural person is the beneficiary. The IRA must be distributed within five years. But there’s a narrow exception when the surviving spouse is the sole executor of the estate and also the sole beneficiary of the IRA proceeds that pass through the estate. In that case, the surviving spouse still can execute a spousal rollover within 60 days after proceeds are received from the IRA. But the surviving spouse can’t treat the IRA as an inherited IRA. (IRS Private Letter Ruling 201618011)

That’s a narrow exception and not one that you should rely on.

If you want your spouse to inherit your IRA, you should name him or her as the primary beneficiary. Then, be sure your spouse will be informed of the options for handling the IRA and how to choose the better option.