If you did inherit an IRA account from a deceased relative that was under the age of 70 1/2, you’ll be prompted to elect a distribution option. The options are to take a lump-sum distribution, open an inherited IRA based on the life expectancy method or open an inherited IRA based on the 5 year method. What should you do?
Elect a lump-sum distribution
In this instance, all assets in the IRA are distributed to you at once. You will pay income taxes on the distribution all at once. You may also move to a higher tax bracket depending on the amount of the distribution and your current income level. However, you will not incur the 10% early withdrawal penalty. This is the option in which you will likely pay a significant amount of taxes in year 1.
Open an inherited IRA based on the life expectancy method
You can elect to open an inherited IRA in which the distributions will be based on your life expectancy. Specifically, distributions must begin no later than 12/31 of the year after the account holder died and your annual distributions are spread over your life expectancy. This is determined by your age in the calendar year following the year of death and reevaluated each year. Please note that if there are multiple beneficiaries, separate accounts must be established by 12/31 of the year following the year of death; otherwise, distributions will be based on the oldest beneficiary. You will not incur the 10% early withdrawal penalty.
Open an inherited IRA based on the 5 Year method
There’s another option in which you can elect the 5 Year Method. With this method, you can also transfer the assets into an inherited IRA held in your name. You can withdraw at any time up until 12/31 of the fifth year after the year in which the account holder died. You are taxed on each distribution, but there is no 10% early withdrawal penalty.
What is my best option?
Of the above options, the method to open an inherited IRA based on your life expectancy will help you defer your tax exposure over time. This may be of interest to you, if you’re looking to reduce your tax liability in year 1.
