IRA is an acronym for individual retirement account, and anyone who earns employment income can open one. A traditional IRA is funded with pre-tax dollars and those funds are taxed upon withdrawal. A Roth IRA is funded by after-tax dollars and thus, future withdrawals are tax free. With both types of IRAs, the death of the IRA owner will result in an inherited IRA and in certain cases, a beneficiary IRA as well.
An inherited IRA is an IRA that you inherit from another person after the death of that person. There are generally two types: spousal inheritance and non-spousal inheritance. Spousal inheritance occurs when one spouse passes away and the remaining spouse inherits the IRA. A non-spousal inheritance occurs whenever you inherit an IRA from someone that isn't your spouse. Both inheritances allow the inheritance receiver to continue to enjoy tax-deferred investing that increases the value of the IRA over time.
All IRAs must designate a beneficiary, which is the person or entity named by the owner of the IRA to receive the IRA upon the death of the owner. A beneficiary IRA is an IRA opened by the beneficiary to receive the inherited IRA assets. The beneficiary will also need to designate a beneficiary for the new account. This person or entity, called a successor beneficiary, will receive the IRA account at the time of the beneficiary's death.
With a spousal inheritance, the spouse isn't required to open a beneficiary account and can simply roll the inherited funds into her own retirement account. If the inherited IRA is not from a spouse, the IRA is placed in a beneficiary account and the Internal Revenue Service requires this new beneficiary account to be retitled. This means both the name of the decedent and the name of the beneficiary must appear on the account. Such designation allows the beneficiary to stretch out the withdrawals from the inherited IRA across his lifetime. If the beneficiary IRA is titled in the name of the beneficiary only, this will trigger immediate taxation on the entire value of the account if the IRA is a traditional IRA. If the IRA is a Roth IRA, the retitling requirement still applies; however, the beneficiary will generally not have to pay any taxes.
How the beneficiaries handle an inherited IRA will vary depending on whether the IRA is spousal or non-spousal. A spousal beneficiary can do certain things with the account that a non-spousal beneficiary cannot. For example, a spousal inheritance permits the surviving spouse to not only roll over the inherited account into her own IRA account, but the spouse can also continue contributing to it. Non-spousal beneficiaries cannot adds funds to an inherited IRA. Also, a spouse is permitted to cash out the inherited IRA, although doing so may present certain tax consequences, so consult a tax professional before doing so.