Financial Advice for Retirement, Social Security, IRAs and Estate Planning

What’s the Best Option for a Spouse Inheriting an IRA?

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As we discussed last week, the rules for a spouse inheriting an IRA are murky at best.

The best option?

It usually depends 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, with no 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.

(That is, unless the spouse qualifies for one of the exceptions to the penalty other than that the assets that were inherited.)

However, 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, 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 can always 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 is substantially younger than the deceased spouse.

In that case, under the inherited IRA, the surviving spouse might be forced to begin required minimum distributions (RMDs) at an early age, even before turning age 59½, depending on the age difference between the spouses.

Yet, the required minimum distributions 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 required minimum distributions, the next generation of beneficiaries must begin required minimum distributions 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 takes RMDs, because the first deceased spouse would have reached age 70½, the next generation of beneficiaries must continue the distribution schedule the surviving spouse was using.

When the spousal rollover is used, the rules are similar.

If the surviving spouse hasn’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 has begun RMDs, 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.

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