Be sure you understand your options. When the owner of an IRA passes away, his or her heirs must be aware of the rules and regulations affecting Inherited IRAs. Ignorance can lead straight toward a tax disaster.
Please note
that this is simply an overview. Rather than use this article as a guide, use it
as a prelude before you talk to a financial services professional well-versed
in IRA rules and regulations. Inherited
IRA rules are remarkably complex, and that conversation is essential.
First, make
sure you have actually inherited the IRA. Your spouse, parent or grandparent may
have left their traditional or Roth IRA to you in a will, but that doesn’t mean
you have inherited it. In all but rare cases, an IRA beneficiary designation
form takes precedence over a bequest made in a will or living trust. (The same
applies to annuities and life insurance policies.)1
Your first
task is to find the beneficiary form. The financial firm serving as the custodian of
the IRA assets should have a copy on file if you cannot locate one (although
this is not a given).
What if I’m
not the beneficiary named on the form? The IRA assets are destined to go to whoever the
primary beneficiary is. One or more contingent beneficiaries are also usually named;
if the primary beneficiary is now deceased, then the contingent beneficiaries
will inherit the IRA assets.2
What if no
beneficiary is named on the form? Then the financial firm supervising the IRA will
choose a beneficiary according to its rules and/or IRS guidelines. It may
decide that the decedent’s estate will be the beneficiary of the IRA, which is
often the poorest outcome in terms of taxation.2
Spousal
heirs who inherit a Roth or traditional IRA have options. Here they are, stated as
straightforwardly as their complexities allow.
You can have the assets rolled over into
your own IRA. This way, you can
withdraw those inherited assets based upon your own life expectancy. If you
transfer the inherited assets into a traditional IRA you already own, you don’t
have to take Required Minimum Distributions from those assets until age 70½. If
you transfer the inherited assets into a Roth IRA you already own, you don’t
have to take RMDs from those assets at all. (Inherited Roth IRA assets can only be rolled
over into Roth IRAs; inherited traditional IRA assets can only be rolled over
into traditional IRAs.) Only spouses have this rollover option.3,4
You can transfer the assets into a new
Inherited IRA in your name. If your
spouse was older than 70½ when he or she died, then you must start taking RMDs from
the Inherited IRA by December 31 of the year after the year of your spouse's
death (or pay penalties to the IRS). If your spouse passed before age 70½, you
might be able to postpone RMDs until the date when your spouse would have
turned 70½.3
You can create an Inherited IRA to house
the assets, and then roll over the assets from the Inherited IRA into a new
Roth IRA in your name. Yes, you will
pay taxes on the Roth conversion. The upside is that the assets will go into a
Roth IRA, paving the way for no RMDs, potentially lifelong contributions and
tax-free withdrawals.3,4
You can “disclaim” all or some of the
inherited assets. If you don’t want
or need the money from an Inherited IRA, here is another option. By doing this,
the disclaimed inheritance can go to the contingent (or successor) beneficiary
named on the beneficiary form. Spousal IRA heirs sometimes do this with the
goal of reducing income and estate taxes.3
What choices do non-spousal heirs have? Before discussing that, it is worth noting that
non-spousal heirs often get little or no guidance when it comes to Inherited
IRAs. Too often, the financial firm overseeing the IRA just asks, “What do you
want to do?” Often the IRA heir doesn’t know what to do.
First, ask the financial firm overseeing
the IRA to help you retitle it as an Inherited IRA. This has to be done by
September 30 of the year following the year in which the original IRA owner
passed away. Usually the new title for the Inherited IRA is something like
“Mary Jones IRA (Deceased 8/25/2015) for the benefit of Thomas Jones,
beneficiary.” This retitling tells the IRS that this is now an Inherited IRA
(for which you may name a beneficiary).5,6
This retitling is a key first step to a direct rollover of the Inherited IRA
assets – a transfer of those assets from the financial firm the original IRA
was held with to the financial firm your investments are held with. If you are
a non-spousal IRA heir, this direct rollover (also called a direct IRA-to-IRA
transfer) is very important. It gives the funds a chance to have further
tax-advantaged growth.
Non-spousal heirs have a basic either-or
choice when it comes to withdrawals from Inherited IRAs. They can either take
lump-sum withdrawals or Required Minimum Distributions (RMDs).
Usually, your
poorest option is a lump-sum withdrawal. If you touch the money at any point – that
is, if the IRA custodian cuts you a check for the Inherited IRA assets and you
deposit it in a bank account or IRA you have – that is not a direct rollover.
That is an indirect rollover, and the entire amount withdrawn
is treated as taxable income by the IRS. (An exception: if you cash out an Inherited Roth IRA, it is not a taxable
event if the Roth IRA has existed for five or more years.) A direct rollover –
in which only the custodian brokerages touch the money as they transfer it from
one IRA to another – is not a taxable event.5,6
Taking RMDs
is usually the better option. A beneficiary can arrange RMDs from an Inherited
IRA, with the following variations:
Does the
Inherited IRA contain assets originally held in a traditional IRA? If so, the beneficiary
must schedule RMDs over his or her life expectancy if the owner of that
original, traditional IRA died after age 70½. If the original IRA owner passed
away before age 70½, a beneficiary can either take RMDs based
his
or her life expectancy or by the 5-year method (whereby the entire Inherited
IRA balance is depleted incrementally in five years).6
Does the
Inherited IRA contain assets originally held in a Roth IRA? If so, the beneficiary
can schedule RMDs over his or her life expectancy or by the aforementioned
5-year method. The age at which the original IRA owner died is irrelevant.6
Generally speaking, the RMDs must start by
the end of the year following the year in which the original IRA owner passed
away. If you don’t start taking these required withdrawals by December 31 of
the following year, you will pay a penalty. Taking smaller withdrawals allows
some of the IRA assets to stay invested with tax deferral, and it spreads the
income tax liability on the Inherited IRA money over a multi-year period.3
What other
things should IRA heirs know? Well, here are three important notes in closing.
Non-spousal
heirs cannot contribute to an Inherited IRA. Spousal heirs who elect not to treat an
Inherited IRA as their own or roll it over to their own retirement account also
lose the ability to contribute to an Inherited IRA.7
You may be
eligible for a tax deduction related to Inherited IRA income distribution(s). Income from an Inherited
IRA is what the IRS terms “income in respect of a decedent.” This means you can
take an income tax deduction for the portion of the estate tax attributable to
the Inherited IRA (this is detailed in IRS Publication 590).5
If multiple
beneficiaries are inheriting the IRA, you may be able to split the IRA up. Some IRA custodians
allow division of Inherited IRA assets among multiple beneficiaries.5
So if you inherit an IRA, study the rules.
The more informed you are and the more guidance you have, the better the
potential outcome.
This material was prepared by MarketingPro,
Inc., and does not necessarily represent the views of the presenting party, nor
their affiliates. This information has been derived from sources believed to be
accurate. Please note - investing involves risk, and past performance is no
guarantee of future results. The publisher is not engaged in rendering legal,
accounting or other professional services. If assistance is needed, the reader
is advised to engage the services of a competent professional. This information
should not be construed as investment, tax or legal advice and may not be
relied on for the purpose of avoiding any Federal tax penalty. This is neither
a solicitation nor recommendation to purchase or sell any investment or
insurance product or service, and should not be relied upon as such. All
indices are unmanaged and are not illustrative of any particular investment.
Citations.
1 - bankrate.com/finance/retirement/ira-beneficiary-form-mistakes-to-avoid-1.aspx
[9/24/14]
2 -
irahelp.com/slottreport/there-no-beneficiary-retirement-account-now-what [1/9/14]
3 - fidelity.com/retirement-ira/inherited-ira/learn-about-your-choices
[10/7/15]
4 - news.morningstar.com/articlenet/article.aspx?id=716642
[10/7/15]
5 - retirementwatch.com/IRASample1.cfm
[10/7/15]
6 - fool.com/investing/general/2015/09/28/the-inherited-ira-its-a-great-gift-but-learn-the-r.aspx
[9/28/15]
7 - finance.zacks.com/can-contribute-inherited-ira-5545.html
[10/7/15]
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