In 2012, I lost my mom. She’d fought cancer and lost, and it devastated me at the time. Because she knew the end was coming, she made preparations and her estate was well-organized. One of the things she left behind was her IRA. I no longer get to talk to her, laugh with her or share a meal. Every year, though, she still sends me one tangible gift to remember her by: a distribution from the IRA she left behind.
If you inherit an IRA, you’ll need to decide what you are going to do with the IRA before you take control of it. That’s important, because if you do it wrong, you can leave yourself with limited options and a huge tax bill.
Your choices are different if you inherit the IRA from a spouse.
If you inherit an IRA from your spouse, you have the ability to transfer it into your existing IRA (or treat is as your own). That’s important, because that option is only available to spouses, and is less restrictive than the other IRA options. If the IRA money is in your own IRA, you can still contribute money to it as long as meet all of the other requirements. You won’t have to take required minimum distributions until the year you turn 70 ½. You’ll have all of the benefits and restrictions of having your own IRA.
If you inherit an IRA from anyone other than your spouse, you don’t have the option of transferring it to your own IRA. You have 2 choices, which are also open to spouses. You can take all of the money out of the IRA by December 31st of the 5th year after the death of the original owner. This means big distributions, taxed at your highest marginal tax rate.
Your other option is to transfer the IRA into an inherited IRA and take minimum distributions based on your life expectancy each year. If you take the minimum distribution route, you will have to begin taking distributions before December 31st of the year after the death of the IRA holder. Miss that deadline and you’ll have to go with the 5 year plan or pay a huge penalty.
Some of the rules for inherited IRAs depend on the age of the account holder.
If the owner was already taking minimum distributions from a non-Roth IRA, you’ll need to make sure they took one in the year of their death. If they were taking distributions, you’ll need to use their minimum distribution calculation to take the first distribution in the tax year of their death rather than your own. Miss that December 31st deadline, and you may owe a penalty of 50% of the required minimum distribution.
This can cause a problem if you lose an account holder over the age of 70 ½ late in the year. You may not find out that they didn’t take a distribution until after the deadline.
Spouses who take the inherited IRA option have the ability to defer taking minimum distributions until the year the deceased spouse would have turned 70 ½. This can delay the distribution, allowing a longer tax deferral and a bigger balance.
It transfers outside of the estate, unless the account owner didn’t set up a beneficiary.
An inherited IRA transfers outside of probate using the beneficiary designations that the account holder set up. That’s one reason you need to keep those beneficiary designations up to date.
If there’s no designated beneficiary, though, the IRA becomes part of the estate. If the account is part of the estate, the inheritors can only use the 5 year plan and can’t set up an inherited IRA.
Because most IRA transfers occur outside of probate, you can probably get it transferred faster and with less fuss. My brother and I were able to get the inherited IRAs squared away within a matter of weeks, while the rest of the estate took much longer.
The IRA still impacts the estate if the estate is large enough. In those rare cases that an estate reaches taxable level, the IRA is included in the value of the estate. Holders of inherited IRAs can deduct the amount of estate taxes incurred due to the IRA.
You don’t have to maintain the inherited IRA as one account. If you have multiple beneficiaries, splitting it up makes more sense.
If multiple beneficiaries are named to an inherited IRA, then each beneficiary will probably want to set up their own inherited IRA. (Which is what my brother and I did). Otherwise, minimum distributions are calculated by the beneficiary with the shortest remaining lifespan. That leads to larger distributions and larger possible tax burdens.
Unless it’s an inherited Roth IRA, you will pay taxes on distributions.
Whether you take distributions as a minimum distribution over time, a stream of payments over 5 years, or a lump sum payment, you will need to treat the distribution as income and report it on your tax return. That means that if you aren’t careful when you take control and you cash the IRA out, you may end up owing a big tax bill.
Say you file your taxes as single and make $50,000 a year. Because you’ll take at least $10,000 off your taxable income through the standard deduction and personal exemption, you pay most of your income taxes at the 10 or 15% rates. Only a small part of your income is taxed at 25%, your highest marginal rate. Then you inherit an IRA worth $20,000. If you take the lump sum distribution, you’ll owe additional federal income tax all at the 25% rate. So you will pay an additional $5000 in income taxes that year. Since you probably haven’t withheld extra, you may owe penalties and interest as well.
Even if you cash the inherited IRA out and try to put it into your own IRA account, you’ll still owe taxes on the distribution. That’s why I emphasized that you need to know what you are doing before you take control of the account.
If your inherited IRA is a Roth, the investments were made with after-tax money, so you will not have to pay taxes on regular distributions unless the account was set up less than 5 years previously. Your basis on the Roth will be the original account basis.
You can change the investments in an inherited IRA.
While you don’t have the option of putting additional funds in an inherited IRA, you do have the option of changing the investments. This can be very valuable if you are younger and want to take more risk than the account owner. The ultimate value of the inherited IRA depends on your rate of return, so you will want to make sure your investments fit you and your investment goals.
What I Did
An inherited IRA can provide you with tax-deferred growth and a steady stream of income for life, but only if you don’t screw up. You have a limited time window, but you still want to make good decisions so that you set yourself up for the best long-term outcome.
When I inherited my IRA, I knew some of the rules and worked with my Mom’s financial advisor to make sure that the IRA transferred correctly to an inherited IRA. I wanted to make sure I had a long term asset that provided income over many years.
To make things easier, I kept the account with Mom’s advisor during the transition, even though he is in a different city. There was a bit of paperwork back and forth, but when we finished, I had an account that basically pays for the Christmas gifts I give each year. To keep the distribution from incurring unexpected tax penalties, I make sure to withhold taxes. I changed some of the investments, and I monitor the account.
These may not be your choices, but they worked for me.
Don’t Miss your Opportunities on Inherited IRAs.
Have your plan. If you are going to transfer the account to a new inherited IRA, make sure you set up the new account correctly so that it transfers directly between accounts with no tax-triggering distributions. This is especially true if you are transferring between IRA providers. You may want to get the money transferred to an inherited IRA within the same financial institution and move the account later to reduce the chance of a mistake. Know how much of a distribution you need to take, and take it by the correct dates to avoid penalties.
If you inherit an IRA, you likely have lost someone you love, and you have a wealth of details to look after. Taking care of the details on an Inherited IRA may be one of those times when it makes a lot of sense to get some professional guidance before you take any actions. It can be a tricky process, and even experienced investors may need some help to get all of the details right. The tax penalties for messing up can be huge on larger IRAs. If you have any doubts whatsoever, get expert help.
It’s important that you get the best value for your inherited IRA. It may be the last gift your loved one is able to give you.
Have you ever inherited an IRA? What do you think the best course of action is? When do you think you absolutely need to get expert financial advice?
This article is for informational purposes only. As indicated above, those who inherit an IRA would do well to seek out assistance from experts on Inherited IRAs.
First Written October 16, 2016 and republished on September 7, 2016.