The Rules For An Inherited IRA
So, you’ve inherited an IRA from someone. That’s great, but there’s a lot at stake. Manage it well and the amount will represent a secure nest egg for you and your family. Make the wrong moves and it may vanish quickly, and you may be left with a big, fat penalty from the IRS.
There are a lot of things you must know to make the right decisions about how to preserve and access the funds. Consider the following to be a condensed checklist.
Are You Designated As The Beneficiary?
Is the IRA really yours to use? It may have been left to you in a will or in a living trust, but are you listed as the recipient on an IRA beneficiary designation form? This form almost always takes precedence over a bequest made on any other document. You need to see that form. If you’re the beneficiary, chances are you have it or know where to find to it. But if you’ve misplaced it or you never had it, ask the financial services firm that is holding the IRA’s assets. It will have that document.
If the beneficiary listed on the form is dead, the IRA’s assets will go to the contingent beneficiary, if one is named. If there isn’t a contingent beneficiary named, the IRA most likely will go to the estate.
Next, learn about the rules for inheriting an IRA. They’re different, depending on if you’re the spouse or a child or someone else.
Are You The Spouse Of The Original IRA Owner?
If you’re the spouse, you have three options:
Roll Over The Assets Into A Beneficiary IRA: If you do this, you may withdraw money from the IRA based upon your own life expectancy and you can wait until the year in which the original IRA owner would have turned 70½ years old to start taking required withdrawals from the IRA. The withdrawals, known as required minimum distributions, are calculated for each account by dividing the balance on Dec. 31 of the previous year by a life expectancy factor that the Internal Revenue Service publishes in Publication 590.
Convert It Into Your Own IRA: If you don’t have one, you can create one for this purpose and contribute to the account to delay required minimum distributions until you turn 70½. If you withdraw money from the IRA before you reach age 59½, you likely will be subject to a 10 percent early-distribution tax, though exceptions may apply. If the IRA is a Roth IRA, the surviving spouse should ask if he or she is able to receive tax-free income earlier than the five-year waiting period.
Disclaim All Or Some Of The Assets In The IRA: If you don’t want the money or don’t need it, then the money can go to the contingent beneficiary, and you can reduce your income and estate taxes.
If You Are Not The Spouse
The options for a non-spouse are a bit murkier, and accountants and financial advisers often differ on the best approach.
Re-Title The IRA
You may ask your financial adviser to help you re-title or re-register the IRA so you can rollover the assets to your IRA. This re-titling also lets the IRS know that it is an inherited IRA. You need to do this by Sept. 30 of the year after the year in which the original IRA owner died. If you don’t bother to re-title the inherited IRA funds and simply deposit them into your IRA, the money you inherited will be treated as taxable income. Even if it’s a small amount, this tactic is unwise.
If you’re not the spouse, you can’t contribute to an inherited IRA, and you can’t postpone the required minimum withdrawals, but you won’t get taxed on the IRA until after you start making withdrawals. If you don’t need the money from the IRA, you still have to take the minimum withdrawals.
Make Sure You Take The Minimum Distributions
Don’t make the mistake of doing nothing. If you don’t start taking these required withdrawals by Dec. 31 of the year after the year the IRA owner died, the IRS will penalize you by taxing the amount you fail to withdraw at 50 percent. The penalty may be waived if the account owner establishes that the shortfall in distributions was due to a “reasonable error.” In order to qualify for this relief, you must file Form 5329 and attach a letter of explanation.
The good news is you may be eligible for a tax break if you’re withdrawing money from an inherited IRA. The IRS calls this money “income in respect of a decedent.” You may be able to receive an income tax deduction for the portion of the estate tax attributable to the inherited IRA. For more detail, see IRS Publication 590.
If more than one person is inheriting the IRA, you may be able to divide it into multiple IRAs.
If you inherit an IRA, do your homework and consult with a trusted accountant or financial adviser. The more you know, the better off you’ll be.