Posted by Judith Sanborn, CFP®, AIF®
What you should know in order to benefit the most from this type of inheritance.
An inherited individual retirement account or IRA, lies at the tricky 3-way intersection of estate planning, financial planning and tax planning. One wrong decision can lead to expensive consequences. The first thing to do if you are a beneficiary of an IRA is to meet with a financial adviser who can explain your options. The worst thing you can do is to cash out the plan. Distributions from an inherited traditional IRA are 100% taxable as ordinary income. Distributions from inherited Roth IRAs are not taxable.
Choose 5-year rule or stretch IRA
The money in an inherited IRA must be taken out eventually, except in some cases when the beneficiary is the spouse of the deceased.
Non-spouse beneficiaries have 2 options for liquidating the account:
- They can choose to take distributions over their life expectancy known as the stretch option, leaving funds in the IRA for as long as possible
- Or they must liquidate the account within 5 years of the original owner’s death.
The stretch IRA is the tax equivalent of the treasure at the end of the rainbow. Hidden beneath the layers of rules and red tape is the ability to shelter funds from taxation while they grow for decades. In the case of a Roth IRA, earnings accumulate tax-free.
One slip-up by the beneficiary or even by the benefactor before death, and that tax gem can be lost forever. Instead the beneficiary will be forced to take the money out of the IRA under the 5-year rule. For substantial accounts, that can add up to a monstrous income tax bill-unless the IRA is a Roth, in which case taxes were paid before money went into the account.
Spouses hit the jackpot
When it comes to inheriting an IRA, spouses can basically take the account and treat it exactly as if it were their own. If you don’t need the money, you do not have to take a distribution until you reach age 70 ½.
Spouses are able to rollover the IRA into an account for themselves. That resets everything. Now they are able to name their own beneficiary that will succeed them and be able to deal with the IRA as if it is their own.
Non-spouse beneficiaries must act soon after they inherit an IRA
Nonspouse beneficiaries can be done in by procrastination. In order to choose the stretch option, a beneficiary must take yearly required minimum distributions or RMDs, based on his or her own life expectancy.
There is a cutoff date for taking the first RMD. You must take the first distribution by December 31st of the calendar year following the year that the decedent died. If you miss this date, you default to the 5- year rule
Be aware of year –of- death RMDs
Another hurdle for beneficiaries of traditional IRAs is figuring out if the benefactor had taken his or her RMD in the year of death. If the deceased had reached 70 ½, the RMD must have been taken out before the beneficiary can rollover this inheritance into their own IRA. If you don’t do this, you’re liable for a penalty of 50% of the RMD. The last day of the year is the deadline for taking that year’s RMD. Not surprisingly, that can cause a problem if someone dies late in the year.
Don’t ignore beneficiary forms
An ambiguous, incomplete or missing designated beneficiary form can sink an estate plan. Many people assume they filled out the form correctly at one point. If there is no designated beneficiary form and the account goes to the estate, the beneficiary will be stuck with the 5-year rule.
Make sure your beneficiary designation form is correctly completed on all your IRAs, 401ks, etc.
Improperly drafted trusts can be bad news
It is possible to list a trust as a primary beneficiary of an IRA. It is also possible that this will go horribly wrong. Done incorrectly, a trust can unwittingly limit the options of beneficiaries. Provisions of the trust must be carefully drafted. The trust needs to be drafted by a lawyer who is experienced with the rules for leaving IRAs to trusts. Naming a trust as the primary beneficiary of an IRA is generally not recommended.
Not all IRA custodians are equally adept
Some custodians are more versed than others in the complex rules surrounding inherited IRAs. Make sure your custodian is familiar with these rules. One mistake made on the part of the custodian, or bad advice, leaves difficulties for the beneficiaries as discussed above.
If you’re getting conflicting advice or something seems wrong, don’t sign anything that could lead to a decision that might be irreversible. Get a second opinion from someone with expertise specific to the inherited IRA area.
I repeat the advice in the first paragraph of this blog: The first thing to do if you are a beneficiary of an IRA is to meet with a financial adviser who can explain your options.