When it comes to losing a spouse, there are often many unexpected details to deal with, not the least of which is financial. One such detail is what to do if you’ve inherited a traditional IRA from your spouse. Spouses who inherit a traditional IRA have several choices to make, and each could impact your income tax bill in different ways.
If your spouse was under 70 ½ when he or she passed away, you have several options to access the money without incurring the 10 percent early withdrawal penalty. However, you will owe income tax on each withdrawal from an inherited IRA. So, it’s important to understand what your income tax liabilities will be using each withdrawal method.
[Read: How to Manage an Inherited IRA.]
Spousal transfer. The lowest-cost option is often to treat the IRA as your own. You could roll your spouse’s savings into your existing IRA and leave it to continue to grow for years. This could help your spouse’s traditional IRA funds to accumulate for as many years as possible. When you need to begin withdrawals, taking distributions in smaller amounts over your lifetime could provide you with additional retirement income each year and keep you within your current income tax bracket.
You can adopt your spouse’s IRA as your own by transferring the full balance into a new IRA in your name or into your existing traditional IRA. Then, the IRA balance is subject to the same traditional IRA rules as your existing account. You will need to wait until age 59 ½ to withdraw the money without incurring the early withdrawal penalty.
Inherited IRA. With this option, you open a special type of IRA called an inherited IRA. You will have to take required minimum distributions starting the year your spouse would have reached age 70 ½. RMDs are based on your life expectancy and will be reevaluated annually. You can use this option for an account with multiple beneficiaries, so long as each beneficiary opens a separate inherited IRA by the end of the year following your spouse’s death.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
Lump sum. You can choose to take the full balance of the account as a distribution all at once. You won’t incur the 10 percent early withdrawal penalty on this amount, but the entire distribution will be counted as income in a single year. Taking an IRA distribution as a lump sum can bump you up by one or more tax brackets, resulting in a much higher income tax bill than you would have had otherwise. However, if you are making payments on debt, taking a lump-sum distribution may be a better option than filing for bankruptcy. Using part of the IRA funds to pay for the necessary income tax and putting the rest toward debt could put you on firmer financial footing moving forward.
5-year method. Spouses also have the option to disburse the entire amount in the inherited account within five years without incurring the 10 percent early withdrawal penalty. Spreading the withdrawals over five years can sometimes make the income tax bill more manageable, while still allowing you to use the money without penalty before age 59 ½. However, the income tax implications are still more significant than spacing the withdrawals out over your lifetime.
[See: 10 Reasons to Save for Retirement in a Roth IRA.]
If your spouse was over age 70 ½ at the time of his or her death, you must continue with the existing required minimum distribution schedule until the end of the calendar year. After that, the surviving spouse can treat the IRA as his or her own and take distributions over his or her own life expectancy. If the surviving spouse is younger, this can result in smaller required minimum distributions and a reduced tax bill. Remember to factor the tax implications into whichever withdrawal method you choose.
The best inherited IRA withdrawal strategy depends largely on your particulars, including your age, savings, income level and the amount in the inherited IRA. It’s important to run the numbers for each withdrawal option, and select the distribution method that will be the best choice for your financial needs.
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What to Do When You Inherit a Traditional IRA From Your Spouse originally appeared on usnews.com
