A beneficiary IRA is an option available to you if you inherit an IRA. Although the terms "beneficiary IRA" and "inherited IRA" sound similar, an inherited IRA comes first. A beneficiary IRA results if you treat the inherited IRA in a specific way.
Inheriting an IRA
The rules for inheriting an IRA are different depending on whether you’re the deceased’s spouse. If you are, the law allows you to roll over the inherited IRA into your own IRA. This allows you to delay taking required minimum distributions or RMDs, until age 70 1/2.
If you’re a non-spouse beneficiary, the situation becomes more complicated and less favorable. Generally, you must begin to take distributions from the IRA by Dec. 31 of the year following that in which the deceased died. You can take the payments based on the deceased’s age and life expectancy, or your own. If you use your own, this stretches out the IRA, giving it additional years to grow. If you don’t begin taking distributions by Dec. 31 of the designated year, the account only can grow for five more years – you must withdraw everything by that deadline. Depending on the size of the IRA and your income, this may push you into a higher tax bracket.
The rules for distributions are similar for both Roth IRAs and traditional IRAs, but there are some differences. Although the original owner of a Roth IRA doesn’t have to take RMDs, you only can take distributions from a Roth account based on the original owner’s life expectancy. You can’t stretch them out based on your own. Your other option is to withdraw all the money within five years. In either case, however, it’s not taxable as income if the Roth IRA was funded for at least five years.
Opening a Beneficiary IRA
Another option if you're a non-spouse is to open a new IRA to accept the account you inherited, called a beneficiary distribution account or sometimes a beneficiary IRA. You still must begin taking distributions immediately, just as you would if you had taken them from the original account. But if you’re younger than 59 1/2, there’s no 10-percent tax penalty as there may be with other types of inherited IRAs when you make withdrawals at this age. You lose the option of taking distributions based on the deceased’s life expectancy with a beneficiary IRA -- they'll depend on your age and life expectancy. You can transfer the original IRA into a beneficiary distribution account and cash out the latter by Dec. 31 of the fifth year.
Making a Choice
In some respects, a beneficiary IRA may seem like an unnecessary step because many of the rules are similar, if not the same. Fidelity Investments advises that if you do decide to go this route, make sure the transfer of the inherited IRA into your beneficiary IRA is direct from one custodian to the other. You don’t get the 60-day tax-free rollover period that spouses enjoy.