Non-Spousal IRA Inheritances
If you inherit an IRA from someone other than a spouse, you cannot treat it as just any other IRA. It’s a totally different animal.
A spouse who inherits an IRA is the only person who can commingle funds with other IRAs. Everyone else must keep inherited IRAs totally separate and may not make new contributions to these accounts.
So, if you think you might inherit an IRA from someone other than your spouse, such as an elderly parent, it’s wise to do some advance planning if you can. Your options for handling the account are a little trickier. In particular, there are some thorny rules regarding designating beneficiaries for IRAs.
In most cases, beneficiaries should be actual, named people — known as designated beneficiaries — rather than simply “my estate” or “my living trust.” Another no-no: leaving blank the space on the IRA beneficiary form (available from the financial institution that holds the account) in the mistaken assumption that the account automatically will be distributed to heirs as part of their will.
Why? Trusts, estates and other entities don’t have life expectancies. If they ‘receive’ an inherited IRA, they must draw down,and pay taxes on, the entire IRA account within five years or according to distribution plan of the original owner, if the owner had already begun taking distributions before his or her death.
On the other hand, if you directly inherit the account as a designated beneficiary, you have more choices on how to handle withdrawals. You can even stretch out distributions over your own life expectancy. That’s where we get the term ‘stretch IRA.'” Stretch IRAs are also known as “legacy,” “super” and “multigenerational” IRAs.
If you are one of several beneficiaries of an inherited IRA (say you’re sharing it with three siblings), separate the account as soon as possible. Each of you then can choose how to handle your own account.
A non-spouse who inherits an IRA generally has three choices:
Remain a beneficiary. In this case, you’ll transfer the IRA assets into a beneficiary distribution account, also called a beneficial IRA, described earlier. It remains an IRA, with both your name on the account as beneficiary and the deceased person’s name as the original account holder. Example: “John Smith IRA (deceased April 12, 2004) F/B/O (for the benefit of) Elizabeth Smith, beneficiary.
Make certain the financial institution does not put the IRA directly into your name. Doing so would make the inherited IRA fully taxable in one year.
As the beneficiary of an inherited IRA, you will forevermore need to make at least the annual required minimum distributions from the inherited IRA, regardless of your age. The age 70 1/2 guideline for beginning withdrawals no longer applies to this inherited account. You’ll need to make withdrawals every year — withdrawing the entire amount either within five years or “stretching” it over your life expectancy.
Non-spouse beneficiaries usually also can move an inherited IRA, via a direct trustee-to-trustee transfer, to another financial institution. In addition, you can change the way the money is invested. For instance, if your dad invested his IRA money in bond funds, you aren’t stuck with his choices. You can opt to reinvest the money in growth mutual funds.
Cash out the account so it is no longer an IRA. If you cash out the account, keep in mind that the funds are immediately considered taxable income for that year. Talk with a tax pro before you make this decision, especially if a significant amount of money is involved.
Give it away. If you’re doing well financially, you might choose to give your inherited IRA to someone else so the account can grow tax-deferred over a lifetime. This option should be discussed with the original IRA account holder while still living. You may also need to seek legal advice.
One way to handle this situation would be to have the original account holder — your mother, for instance — designate your son as her IRA beneficiary to begin with. Another option would be for your mom to list you as the primary beneficiary and your young son as the contingent, or secondary, beneficiary.
In the latter case, you could then choose to disclaim, or give up control of, the IRA while the estate is being settled. The account would then pass to your son, the contingent beneficiary.
A “disclaimer,” also known as a “renunciation form” in legalese, is a written statement of the primary beneficiary’s desire to give up the inherited IRA. In most cases, a disclaimer must be filed with the court within nine months of the original account holder’s death or by Sept. 30 of the year following the account holder’s death, whichever is earlier.
However, the key to this entire giveaway is that your son must be listed on the deceased mom’s original IRA contract as the approved contingent beneficiary. You cannot simply give the tax-deferred account to him on your own, after your mother’s death.
If a parent wants to leave an IRA to several designated beneficiaries, he or she can take action while still living to separate the account. For instance, if a father has three children, he can divide his IRA into three separate IRAs and designate each child as the beneficiary of one of the accounts. This move can simplify things once the father dies and the estate is distributed.
The taxman is watching
A particularly important factor to consider after inheriting an IRA is whether the original account owner had begun taking annual withdrawals from the account. Why? If you don’t know whether withdrawals have begun, you could give the IRS an opportunity to step in and take a significant portion of the account in taxes and penalties.
If the account owner was 70 1/2 or older when he died, he should already have begun taking annual distributions. If not, the IRS can assess a 50 percent penalty on the amount that should already have been taken out. The estate must handle these penalties and any owed taxes before beneficiaries — you — receive any money.
Also, if you simply sit on an IRA after inheriting it and fail to continue taking distributions, you’ll end up with a big tax and penalty bill later. The amount you, as the designated beneficiary, are required to withdraw from an inherited IRA can vary. You shouldn’t count on the financial institution that handles your IRA to be familiar with inheritance rules. A tax professional is a wiser choice for guiding you through these muddy waters.
The Roth IRA difference
Unlike traditional IRAs, the Roth is not subject to distribution rules, so the account holder is not required to start distributions at 70 1/2. And upon the account holder’s death, a spouse can keep the Roth IRA intact, roll the proceeds into a new or existing IRA account and may continue to contribute to the account. There would be no requirement to take distributions.
A non-spousal beneficiary, on the other hand, must take distributions either by the end of the year marking the fifth anniversary of the account holder’s death or over the life expectancy of the beneficiary, starting no later than Dec. 31 of the year following the year the account holder died. No matter how the beneficiary decides to take the Roth IRA distributions, none would be subject to the 10 percent early withdrawal penalty.
The tax consequences of these choices should be considered on an individual basis and only after consulting with a tax expert.
Don’t miss the deadline
A final caveat: Don’t wait too long before deciding how to handle your inherited traditional IRA.
You have a little time on your side; the designated beneficiary of an inherited IRA doesn’t need to begin taking distributions from the account until Dec. 31 of the year following the IRA account holder’s death. However, keep in mind that just as the IRS doesn’t accept ignorance of tax laws as a reason for breaking them, it also doesn’t accept grief as an excuse.
For more information, refer to IRS Publication 590, Individual Retirement Arrangements, or Montana State University’s publication: “Inheriting an IRA: Planning Techniques for Primary Beneficiaries.” Many financial institutions also have information available on inheriting IRAs. An informative book on IRAs, with a full section on “stretch IRAs” is “The Retirement Savings Time Bomb .. and How to Defuse It” by Ed Slott.