Inherited IRAs: Requirements and Tips

March 12, 2021

Mat Sorensen

If you’ve inherited an IRA from a parent or another loved one, it is likely that you have an Inherited IRA (aka, Beneficiary IRA). These can be powerful accounts, but you need to understand the Required Minimum Distribution (“RMD”) rules for your Inherited IRA to properly utilize it. The inherited IRA may be a Traditional or Roth IRA, and there are three different distribution options you may elect when you inherit the IRA. These distribution options dictate how you can invest in the account. Please note that if you inherit an account from a spouse, you can just do a spousal rollover and consider the account as yours. This article is for those inheriting an IRA from a non-spouse.

Distribution Options

You will have three distribution options upon the death of your loved one to receive the funds from their IRA. In general, the best option is the “Life Expectancy Method” as it allows you to delay the withdrawal of funds from the IRA, and allows the money invested to grow tax-deferred (Traditional) or tax-free (Roth). The three options are outlined fully below:

1. Lump Sum

The first option is to simply take a lump-sum and be taxed on the full distribution. There is no 10% early withdrawal penalty (regardless of your age or the deceased owner), but you are taxed on the amount distributed if it is a Traditional IRA. You’re also giving up the tax-deferred (Traditional) or tax-free (Roth) benefits of the account. Don’t take this option. It’s the worst tax and financial option available to you.

2. 10 Year or Life Expectancy Method – Stretch IRA

Important update to this method under the SECURE Act signed into law in 2019. Those who have already inherited an IRA in 2019 or earlier can still operate as usual. Everyone else who looked forward to one will have to take solace in the fact that they at least have 10 years of “stretching” to continue investing the funds in a tax-free (Roth) or tax-deferred (Traditional) manner. And, under the new rule, there is no RMD rule in effect each year. Instead, the total amount must be distributed at the end of 10 years. This makes things a little easier with self-directed assets and also helps any IRA owner – 10 years is still a good amount of time – get a little bit of additional tax-deferred (Traditional) or tax-free (Roth) growth.

For those that inherited an IRA in 2019 or earlier the following option is still available, whereby you can take distributions from the inherited IRA over your lifetime based on the value of the account. These distributions are required for Traditional IRAs and even for inherited Roth IRAs. For example, if you inherited a $100,000 IRA at age 50, you would have to take about $3,000 a year as a required minimum distribution each year and the rest can stay invested. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty when you pull money out of the account regardless of your age. Traditional Inherited IRA distributions are taxable to the Beneficiary while Roth IRA distributions are tax-free. And yes, Inherited Roth IRAs are subject to RMD even though there is no RMD for regular Roth IRAs.

3. Five-Year Method

This option is available to all inherited Roth accounts but is only available to inherited Traditional IRAs where the deceased account owner was under age 72 at the date of their death. Under this option, the Inherited IRA is not subject to RMD. However, it must be fully distributed by December 31st of the fifth year following the year of the account owner’s death. There is no 10% early withdrawal penalty, and distributions are subject to tax. Again, this option is only available to Traditional accounts.

Investing with a Self-Directed Inherited IRA

Yes, you can self-direct your Inherited IRA (aka, beneficiary IRA). Before you do, make sure you understand the number of funds you’ll need to take as an RMD, and that you will have available cash in the account to cover those RMDs. As I described above, assume you are 50 and inherited an IRA for $100,000 in 2019 or sooner. You will need to take annual distributions of around $3,000. So, if you invest all of the $100,000 into an illiquid asset, then you will be unable to take RMDs and you will force the IRA account to pay stiff penalties. Consequently, when making a self-directed investment from an Inherited IRA, you must take into account the amount of the investment, the total value of the account, and the timeline of the investment (when will it generate cashback to the IRA). If you inherited the $100,000 account above, you may decide to only invest $70,000 of the Inherited IRA into an illiquid investment (e.g. real estate or private company), while leaving the other $30,000 to be invested into liquid investments like publicly-traded stocks, CDs, cash or mutual funds. This will leave funds available for RMD until such time as the illiquid investment generates income or is sold for profit. If you inherited a $100,000 IRA in 2020 or later you have 10 years in which to take a distribution of the entire account balance which would mean selling the property or asset. You do not need to take annual distributions each year and can wait until year 10 to take the full distribution. Or you can take portions out as you desire over time in the 10-year window.

Stretching out the benefits of an inherited IRA can be powerful, but make sure you plan for RMDs before you make any self-directed investments from your Inherited IRA.

Self-directed Inherited IRA accounts can be set-up in as little as five minutes here at Directed IRA.

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Mat Sorensen

Mat Sorensen

Mat has been at the forefront of the self-directed IRA industry since 2006. He is the CEO of Directed IRA & Directed Trust Company where they handle all types of self-directed retirement accounts, which are typically invested into real estate, private company/private equity, IRA/LLCs, notes, precious metals, and cryptocurrency. Mat is also a partner at KKOS Lawyers. He is published regularly on retirement, tax, and business topics, and is a VIP Contributor at Entrepreneur.com. Mat is the best-selling author of The Self-Directed IRA Handbook, the most widely used book in the self-directed IRA industry.
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